Market Corrections: Short Premium vs. Buy & Hold
May 30, 2019
The other day I was explaining the short premium trading philosophy to a friend. He has plenty of experience trading the financial markets, but mostly via futures, so it was an interesting discussion.
It didn't take him long to understand the strong value proposition presented by selling premium - especially in diversified underlyings like stock indices, and ETFs. After our discussion, he messaged me and said he'd gone through the tastytrade archives and binged on a bunch of videos focused on short premium, probability of profit (POP), and trade management.
One item he wanted to discuss in greater detail was market corrections, and how they impact the short premium approach.
Fortunately for me, a recent episode of Market Measures took on this precise topic, which saved me from having to write a lengthy email - I just forwarded him the link. This got me thinking that other tastytraders might be interested in the new show, as well.
The thing is, the short premium philosophy hinges on a high number of occurrences. Consequently, the most effective way of tapping into the high win rates associated with selling premium is to deploy the approach frequently, consistently, and in a disciplined (i.e. mechanical) manner.
One reason for this is because of corrections, which can pressure short premium positions. At the same time, the overhanging threat of a correction is what can provide the opportunity for such attractive returns in the first place (i.e. the need for insurance).
Speaking of corrections, it should be noted that premium sellers aren’t the only ones exposed to risk when these market conditions materialize. The traditional “buy and hold” strategy is heavily exposed to corrections as well, and in some ways more so than a short premium - as will be covered in short order.
On the aforementioned episode of Market Measures, the team highlights new research conducted by tastytrade that provides further insight into how the short premium and “buy and hold” approaches performed during several historical corrections (2008, 2015, 2018).
The results are extremely compelling, and may help reinforce your confidence when trading short premium, no matter the market environment.
To produce the necessary data for this analysis the Market Measures team designed two different backtests for each of the trading approaches - both involving historical data in SPY.
The first backtest evaluated the performance of a 16-delta short strangle in SPY deployed continuously in 2008, 2015, and 2018. The second backtest simply tracked the performance of 100 long shares of SPY (i.e. buy and hold) through the same three years.
It should be noted that in terms of capital usage, the buy and hold approach was roughly three times more capital intensive than the short strangle approach, on average.
Despite that fact that 2008 was one of the most volatile years in the history of the financial markets, the short strangle approach did in fact outperform the “buy and hold” approach, as highlighted below. And as you can see in the graphic, it wasn’t even close:
Looking at the above data, it’s interesting to consider what most investors would have thought about a side-by-side comparison of the two trading approaches during those periods.
Especially given that the “average” investor tends to think of options as “very risky.” It seems like a safe bet that many would have predicted the buy and hold approach to be safer than short premium - which wasn’t the case at all.
And while investors certainly need to be careful when trading options, the same should be emphasized about “buy and hold.” This point is clearly illustrated by the historical data presented on the show.
On the balance of this particular episode, the hosts of Market Measures also walk viewers through the findings from the backtests for the years 2015 and 2018. This data further underscores the findings from the 2008 backtest, and we hope you’ll take the time to review the complete episode of Market Measures when your schedule allows.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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