Options traders spend a lot of time managing deltas. Often times we enter a trade such as a strangle with a delta neutral position; our put and call have equal and offsetting deltas. Rarely does a position maintain its neutrality without being actively managed. We decided to look at how best to manage these trades when we need to increase deltas in order to get a position back to neutral.
Using SPY as our example and forty-five days until expiration, we compared selling one at-the-money (ATM) put versus selling three out-of-the-money (OTM) fifteen delta puts. Trades were managed at 50% of maximum profit.
It should be no surprise to tastytraders our average daily P/L was higher when selling three of the fifteen delta puts. Our probability of success is higher in those trades. However, when we look at things such as buying power, return on capital and tail risk, the ATM put offered some significant advantages.
Three of the fifteen delta puts costs a little less than $9200 in buying power. For many accounts, that is a substantial amount of capital. By comparison, one ATM put requires less than $4200 in buying power, or roughly half the amount needed for three OTM puts. That had significant implications when considering our return on capital as well.
Tail risk is another consideration. The largest loss in our study when selling three OTM puts was over $3500. However, our largest loss when selling one ATM put was just under $2000. Our average loss when selling three ATM puts was also about twice as large as selling one ATM put.
Many of us, myself included, often default to selling further OTM options because of their greater probability of success. What this study shows; however, is selling more OTM units may not be the best trade. Increased tail risk and buying power are key considerations, especially in accounts with limited capital.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see: