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Portfolio Allocation for Strangles (Part 3)

Market Measures

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

The so-called experts tout passive investing. They claim that a buy-and-hold approach of a broad based index, such as the S&P 500, will outperform active investing. We believe you should take control and can outperform that passive strategy. We are convinced that a premium selling strategy such as shorting 1 Standard Deviation(SD) Strangles can outperform it. The Market Measures from September 26, 2016: "Portfolio Allocation for Strangles: Part 1" tested our concept of short Strangles and managing winners at 50% of max profit (if possible) versus buy-and-hold. The tastytrade way won. The Market Measures from October 3, 2016: "Portfolio Allocation for Strangles: Part 2" tested our concept of closing a trade early, specifically at 21 Days To Expiration (DTE) and the tastytrade way won again. Now in this third part we test our winning ways against each other and look for a way to improve them. Which one of these two is better?

We constructed a portfolio with $1 million of initial capital. Our study was then conducted in the SPY (S&P 500 ETF) using from 2005 to March 2016. We chose the the option expiration cycle closest to 45 DTE and sold 1 SD Strangles, in a regular margin account, and opened a new position only after closing the old one. We then compared strategies of closing the positions 21 DTE before expiration by allocating 10%, 15%, 20%, 25% and 30% of the capital or managing winners at 50% of max profit if possible using the same capital allocation levels.

An 11 year graph of the results showed that on average, the long-term performances of these two strategies were very close. We noticed that managing winners performed better in a bull market but had greater tail risk exposure due to Gamma and that managing earlier largely reduced Gamma risk but resulted in a lower win rate. We ran another study combining the two approaches using a 25% capital allocation. A results graph showed that the combined strategy of managing winners plus managing early greatly improved the long-term performance and yielded 100% higher profits than a buy-and-hold strategy (with SPY used for the index). Additionally, we experienced a third less risk as measured by volatility. A final results graph showed that by using the combined strategy a trader would only need to allocate 16% of available capital to match a buy-and-hold strategy.

For more information on related subjects see:

Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and the compelling results of our final study on Portfolio Allocation for short Strangles, which shows how a combination of two strategies, can greatly improve performance as well as lower your portfolio volatility.

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