A common approach to managing stock positions is to use stop losses. A stop loss is an order type that automatically executes a closing order when a certain loss threshold is reached. How do these mechanics work for short option trades?The Study:
- 45 Days to Expiration
- 2005 – 2018
- 16 Delta Strangles
- Holding to Expiration
- Managing Early at 21 DTE
- Managing Losers at 25%, 50% and 75% of the Original Credit Collected
When we apply stop losses to short strangles we do see a reduction in the volatility of the strategy. However, when we extend the back-test to include cumulative performance results we see that applying stop losses results in very similar performance to holding the position to expiration. Looking at volatility versus return, it appears that while applying stop losses reduces volatility, it’s not worth the sacrifice in returns.