Position Sizing Revisited
Jul 11, 2018
By: Sage Anderson
If you're a frequent seller of straddles and strangles, or considering adding such positions to your portfolio, new research conducted by tastytrade and presented on Options Jive is worth a few moments of your time.
This particular episode focuses on a comparison between increased size when selling a strangle as compared to a straddle with half as many contracts - and the risk implications of each. The underlying reason for this analysis is that some traders may feel positions with higher probability of profit (POP) are good candidates for larger position sizes.
The information presented on Options Jive can help traders better understand the risks of such an approach.
As a reminder, straddles involve selling a call and a put with the same strike price and in the same expiration period. Most straddles are deployed using at-the-money strikes, which means that the time premium in the options can be quite high.
Looking at strangles, which also involve the sale of an equal number of calls and puts, we see a slightly different risk profile. In the case of strangles, the position calls for the sale of a call and a put with different strike prices, but still within the same expiration period.
Another important distinction is that strangles are often traded utilizing out-of-the-money (OTM) options, which have less time premium.
At a high level, that means that the credit received for selling straddles is higher than that of strangles (all else being equal). Given that traders often manage positions by a percentage of the credit received, that in turn means that straddles might (on the surface) look more attractive than strangles.
However, there's more to it than initially meets the eye - especially as it relates to the overall risk profile of the respective strategies. The graphic below helps illustrate this reality:
Notice in the diagrams above how the potential P/L of a straddle is higher than a strangle due to the larger credit, as discussed earlier. On the other hand, we can see that the probability of profit (POP) for a straddle is lower than a strangle.
Given the dynamics of each position, it’s possible a trader may try to compensate for the reduced credit in a short strangle by selling more contracts (i.e. increasing position size). Under that scenario, a trader theoretically increases the amount of premium received, while maintaining the superior levels of POP.
However, one must also recognize that by increasing position size, the trader is now potentially exposed to deeper losses. It’s this precise scenario that the Options Jive team decided to investigate further.
In order to produce the results necessary for a proper analysis, a study was designed that evaluated the historical performance of a straddle and a strangle in SPY. The twist in this particular analysis was that the size of the short strangle was doubled as compared to the straddle.
The two graphics below highlight the findings:
As you can see in the first slide above, the success rate and profit target for a straddle versus a strangle with twice as many contracts were roughly equivalent over the time period examined. However, that only tells us half the story.
Digging deeper into the results, using the second graphic, we can see that the average loser and largest loss increased significantly for the double-size strangle. This second finding is consistent with our expectations for increasing the position size in the strangle, which means that if the position does get tested, the pain is amplified.
While this particular episode of Options Jive focused on straddles and strangles, it serves as a good illustration for any trader that is considering sizing up when they think the odds are in their favor. No matter the approach, increasing position size can open the portfolio up to greater potential losses, and may have the secondary effect of pressuring a trader into bad decision-making (due to outsized potential losses).
The information presented in this episode of Options Jive serves as a good reminder that sizing our positions correctly is paramount, no matter the perceived edge.
If you have any questions about proper position sizing, or any other trading-related topic, we hope you’ll leave us a message in the space below, or reach out directly at email@example.com. To learn more about this topic, we also recommend a previous installment of Tasty Bites.
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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.