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Optionalysis: The Deep OTM Strangle Strategy

Deepak Shenoy10 min read
Quick Facts
What is "Optionalysis: The Deep OTM Strangle Strategy" about?
What category is this article in?
Premium
Who wrote this article?
Deepak Shenoy, Capitalmind's research team.
When was this article published?
Published 27 February 2014.
How long does this article take to read?
10 min read
What does the "What are Option Strangles?" section say?
The idea of an option strangle is write both calls and puts at different strike prices. Assume a stock is at 100.
What does the "You Don’t Have To Wait Till Expiry" section say?
However, you might not have to wait for expiry to make a profit. What if the stock suddenly dips 15% in one day itself, to Rs. 85?
What does the "Writing Straddles on the Nifty" section say?
Now the opposite position is that an index doesn’t move that much so it might be useful to simply write deep out of the money strangles. Many funds have been created to run this kind of strategy. Let's see one of them:
What does the "Wonderful! How Do I Start?" section say?
Wait. That’s the sales pitch. The questions you should ask is:
What does the "Lesson 1: Volatility can kill you. And very fast." section say?
The strategy is quite like picking up coins in front of a roadroller. The roadroller has to only win once.
What does the "How Did We Back Test This Strategy?" section say?
Tech note: It is very complicated. For every month:
What does the "Adding More Layers" section say?
This is a simple strategy. We could make it a little more complex and safer.
What does the "So Why Bother?" section say?
A lot of portfolio managers in brokerages are consistently advising customers to do this and they will convince you to give them power to do it themselves. They will say they’ll give you 2% per month returns. This can be very nice to see, every single month, until one month, they don’t take your calls.
What does the "Closed Out ICICI Position at a Profit" section say?
We’ve closed out the ICICI position at zero, letting it expire worthless. Been giving us scares but it never closed above 1040, which gave us the confidence to hold it through. We did mention a few exit strategies in case this didn't work out (i.e. closed above 1040) but we didn't have to exercise them. I hope this has been a good learning exercise.
What does the "Disclaimer" section say?
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

One of the big option strategies in recent times have been the itch to write option strangles. Many Portfolio Management Services and independent traders have advised this strategy, and it has been an interesting one in terms of theory and practice.

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What are Option Strangles?

The idea of an option strangle is write both calls and puts at different strike prices. Assume a stock is at 100.

  • You buy the 120 call at Rs. 1

  • You but the 80 put at Rs. 1.5

Basically, you pay out Rs. 2.5.

Now you will only make money if the stock is volatile. At expiry you will make money if it ends below Rs. 80 minus (sum of the premiums) 2.5, or Rs. 78.5. Or, you will profit if the stock goes ABOVE Rs. 120+2.5 = 122.5.

The payoff diagram for expiry looks like this:

You lose money (Rs. 2.5) as long as the stock’s within the strangle range. Beyond that you can make unlimited profits. Taking the opposite position is the assumption that the stock or index might move, but won’t move much. Here’s the “short strangle” payoff.

You Don’t Have To Wait Till Expiry

However, you might not have to wait for expiry to make a profit. What if the stock suddenly dips 15% in one day itself, to Rs. 85?

Consider the Long Strangle above. The Rs. 80 put will probably go to Rs. 4 because of the sudden move - it is still out of the money, but less so. Plus, the implied volatility will go up, which raises the time value. At this point, you’ve paid Rs. 2.5 and you can sell one of the options for Rs. 4! The other can even go to zero and you’ll still make a profit.

But if the stock doesn’t move much, then every day, every hour, you will lose time value since you have bought options.

Writing Straddles on the Nifty

Now the opposite position is that an index doesn’t move that much so it might be useful to simply write deep out of the money strangles. Many funds have been created to run this kind of strategy. Let’s see one of them:

  • At the beginning of an expiry cycle, write a put and call that gives you a 5% cover in each direction.

  • Let it run to expiry.

  • If the index moves 5% your positions will end up in a loss. Give it another 2% to jiggle around and at 7% you book the loss. (that is, if the Nifty is higher than your call strike by 2% or below the put strike by 2%)

Assume you take an approximation on leverage of 3x.

That means if Nifty is at Rs. 6,000, one lot of 50 Nifty will be a gross exposure of Rs. 300,000. At a 3x leverage you will trade one lot of Nifty for every Rs. 100,000 you have in the portfolio. Let’s get more aggressive and take Rs. 80,000 per lot.

If we started with the last two months, let’s see how it would have worked. Assume you started on Jan 1, 2014.

  • On Jan 1, the Nifty was at 6300. You want to get cover at 6600 and 6000 (5% on either side).

  • The 6600 call trades at 20.35.

  • The 6000 put trades at 16.75.

The total premium we collect is Rs. 37.10 per Nifty.

Now, let’s assume we own Rs. 300,000 so we’ll write three lots (with Rs. 80,000 per lot as exposure). Margins required for three lots will be less than 100,000, so we can keep the rest in the bank.

One lot = 50 Nifty, so we collect a premium of Rs. 37.10 150 (three lots) = Rs. 5,565*. This is our maximum profit.

Let’s see how this worked out during the month:

For every day, the Call+Put price is what you have to buy back if you had to book the loss today. The profit or loss column simply tells us the daily portfolio profit, marked-to-market.

We made the full profit, luckily. The Nifty was volatile, but it ended only at 6074, above our range of 6000-6600.

If we stretched this into Feb 2014, here’s how the portfolio would have done:

The portfolio sees a total profit of Rs. 10,493 in two months. On Rs. 300,000 that is about 3.5%.

However, the money we required as margin was only Rs. 100,000. If we put the remaining money in the bank, that will yield us another 1.5% in two months (assuming 9% a year) which adds to your return.

(In large portfolios, option margins can be held against a fixed deposit or a liquid fund, so you get the fixed income return on the full amount in the portfolio!)

Wonderful! How Do I Start?

Wait. That’s the sales pitch. The questions you should ask is:

  • How does this strategy do in really volatile times?

  • How much do I lose in a really rough month?

  • What’s the drawdown?

First, we back test this strategy over a longer time. Here’s how it has done in 2013 (full year) till end of Feb 2014:

The way to read the top chart is that the yellow and grey lines are the strikes at which the strangle is written. The dashed lines are the stop losses (2% below the outer strikes). The idea is that if the Nifty hits the stop loss you exit completely.

As you can see, this is an INSANELY BAD strategy.

What has happened is that we build our profits all the way till August. Suddenly the index got really volatile and moved beyond the boundaries (our stop losses) for just two months, and we saw our portfolio drop from a profit of 27,000 to a loss of 29,000!

And again, as volatility fell, we saw the profits rise back. In one year and two months, we have generated profits of just Rs. 4,418, with all that volatility!

We haven’t back tested more, but you can see why - it’s already looking lousy.

Lesson 1: Volatility can kill you. And very fast.

The strategy is quite like picking up coins in front of a roadroller. The roadroller has to only win once.

The good thing is that just one year ago we had enough volatility to back-test this well. If we had back tested a year of data in August 2011, or in July 2007, we would not have seen the recent past being volatile at all!

How Did We Back Test This Strategy?

Tech note: It is very complicated. For every month:

  • I looked at the Nifty value on the first day after the previous expiry

  • I then chose Nifty option strikes based on a +5% and-5% range

  • I put these into an excel sheet that allowed me to plot profits and charts on an ongoing basis.

  • If the Nifty went below the stop loss, I would then assume we exited and “buy back” the options we had sold.

  • Repeat for every month till expiry.

This takes work, but even to elimi

nate a bad strategy, it takes serious amounts of work. Most tools can’t back-test option strategies because the tools are designed to write algorithms to trade ONE instrument based on data - here we will actually trade two options and different ones each month.

Adding More Layers

This is a simple strategy. We could make it a little more complex and safer.

Instead of a fixed 5% away from strike, we use work through the option premiums to get ranges that give us about a 1.5% per month return. This might sound like it is less risky, but think about it - in a good time, no one thinks that the markets will crash. So implied volatility will be LOW. Like in Jan 2008, when the market crashed from 6,200 to 4,800 in a week. Again, the roadroller will run over all the profits you’ve made.

We could “chop off” the edges by buying even more deep out of the money options. This helps curtail edge losses but it reduces the profit accordingly. In fact you might find that profits are so low then that the strategy isn’t worth it.

We could spread the entries over the entire month instead of in one day. This has, in my back-tests, given some excellent returns, but even this strategy has been killed in the extreme volatility zones of:

  • Jan 2008 (Index moved 30%)

  • Oct 2008 (Index fell nearly 40%)

  • May-June 2006 (more than 20% moves)

We can change the strategy to write a straddle instead, and buy deep out of the money puts and calls to support us in case of a large move. Even this, in the preliminary back-tests has the road-roller problem - small profits, but big losses.

We can use the implied volatility to decide to buy or sell strangles. Meaning, if the imp-vols are low, we buy the strangle, and if it’s high, we sell them. This has actually worked well, but the definition of “high” and “low” are very subjective. Before 2008 we would have said high is 40+ and low is 28+ because of the way options were priced then. Today, even 25 looks like “high”, and the current IVs are just 13 which would definitely seem low.

And then, if you wrote option straddles when the market was hugely volatile (in Sep 2013, or in Nov 2008) you would still have lost money. The actual volatility was EVEN HIGHER than the premium on the options were telling you!

So Why Bother?

A lot of portfolio managers in brokerages are consistently advising customers to do this and they will convince you to give them power to do it themselves. They will say they’ll give you 2% per month returns. This can be very nice to see, every single month, until one month, they don’t take your calls.

As a trader too, you find it attractive to sell deep OTM options to “eat premium”. As you can see, the limited vision of the last few months can be an illusion - the real risk is that one month when you find all the money just gone.

There are times when writing options is attractive. For instance, we’ve seen this work in our favour the last two months when we wrote them on individual stocks, or on indexes. But that is not a generic strategy and the particulars of that time was why we took those positions - I would not have done that on just any month.

It’s important to know which strategies don’t really work. A plain vanilla write-deep-OTM doesn’t work. Some of the variants are equally exposed to sudden bouts of volatility which, by the way, happen way more often than one can predict. Therefore instead of saying, “Hey I can do this every month!”, it is important to note that the system itself is based on the expectation that volatility won’t go through the roof.

Closed Out ICICI Position at a Profit

We’ve closed out the ICICI position at zero, letting it expire worthless. Been giving us scares but it never closed above 1040, which gave us the confidence to hold it through. We did mention a few exit strategies in case this didn’t work out (i.e. closed above 1040) but we didn’t have to exercise them. I hope this has been a good learning exercise.

Note: the stock went up over 9% since we sold the call. And we still made a profit! The power was in the strong resistance at 1040 which seems to have held. We will have to re-evaluate positions for next month, as this stock is now on an uptrend, and we should write puts if it crosses 1040 and stays there.

If you have any queries, please mail us at [email protected].

Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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