Losses happen. While they should occur less frequently than winning trades, one bad trade can erase multiple winners. This is especially true when using naked strategies such as straddles and strangles. Although we cannot trade them altogether, just like a hangover, we can create expectations around recovery time.
Modeling losing trades and how long they needed to recover is the most efficient way to formulate expectations. By looking at over 50,000 trades in SPY and TLT, comprised of both straddles and strangles, some conclusions can be drawn.
Selling a straddle brings in the most premium. Think about it. Selling an at-the-money (ATM) put and call will generate more credit than selling anything out-of-the-money (OTM). It seems reasonable to expect the recovery time for straddles to be shorter because of the greater credit received.
Results of the study support the above brain-gasm. The median amount of time required to recover from a losing straddle was eighty-two days for TLT and eighty-seven days in SPY. Seventy-five percent of the time, TLT straddles recovered within 219 days. For SPY, seventy-five percent of the time, trades recovered in 243 days.
Strangles, because they generate less credit, may take longer to recover. Median recovery times for TLT and SPY were 145 and 112 days, respectively. In TLT, seventy-five percent of all strangles recovered within 392 days. SPY had a slightly shorter recovery windows with the same percentage of trades recovering within 349 days.
What this study suggests is, losing sucks. It is easy to see why creating multiple uncorrelated positions is so important. A highly concentrated, short premium portfolio may easily be wiped out with a greater than expected move. Also, losers take time to recover. Uncorrelated positions, actively defended and rolled should help reduce drawdowns and speed up recovery times.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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