While we normally discuss managing trades that are winners, we decided it was equally, if not more important, to discuss what to do with our trades that are losers. This is especially true when trading undefined risk strategies such as the strangle.
To test this, we looked at approximately 5 years of data in SPY. We sold a 1SD strangle on every single day over the test period, choosing the expiration closest to 45 DTE on each entry. This generated a total of 1,313 trade occurrences. As a first step, we wanted to investigate how many of these trades reached a loss that was equal to 1x, 2x, 3x, 4x, and 5x of the credit received. For example, if we sold a strangle for $1.00 and it traded up to $2.00, we considered that a 1x credit loss. For a 4x credit loss, the same strangle would have to trade up to $5.00.
The findings showed that about 17% of the trades reached a 1x credit loss, 8% reached a 2x credit loss, 5% reached a 3x credit loss, 3% reached a 4x credit loss, and only 2% reached a 5x credit loss. Regardless of IV rank, the optimal trade strategy over this time period was exiting the strangles when the loss was equal to 2x the credit received (this means if we sell a strangle for $1.00, we exited when it traded for $3.00). We did not manage these trades for a winner, so if the exit point was not hit, the trades were held to expiration.
Without any regard for IV rank, using the 2x credit loss as an exit point resulted in an ending profit of $99,275 with a win rate of 81%. This was only 3% lower than the win rate of holding the trades to expiration with no exit strategy. Additionally, our max loss was only -$340 with the 2x credit loss exit, as opposed to -$1,325 when holding to expiration with no exit strategy.
In high IV (IV rank over 35), the highest P/L was made when holding the trades to expiration, without using an exit strategy. However, using the 2x credit loss exit point was not far behind. On a max loss and win rate standpoint, the 2x credit loss exit was still a very viable strategy.
In low IV (IV rank below 35), the highest P/L scenario was also using the 2x credit loss. The total P/L was nearly $4,000 greater than holding the trades to expiration with no exit strategy. Also, implementing the 2x credit loss exit strategy resulted in 82% winners, only 2% lower than not using an exit strategy. Finally, with the 2x credit loss exit, the max loss was -$328 instead of -$1,325 when holding to expiration without any pre-defined exit point.
Over the course of the study, the worst drawdown was equal to a 14x credit loss. This means that one loss wiped out approximately 14 trades that ended up being full winners. Limiting our loss to 2x the credit received allowed us to control our drawdowns without sacrificing too much of our win rate. In the future, we will test many more strategies around exiting trades at a loss, in an attempt to better help us preserve capital.