Selling premium in bull markets, especially on the put side, has traditionally been an effective method of producing consistent positive returns.
However, during market corrections, or periods of increased market volatility, strategies employing short premium get “put” to the test.
Having managed a portfolio holding a significant amount of short vega (think 1 million+) during 2008, I can verify the above assertion from a first-person perspective.
Tom Sosnoff and Tony Battista tackled this very subject on a timely Market Measures geared towards short puts, and the reality of taking losses in such portfolios.
As I discovered in 2008, and Tom and Tony discuss on the show, these losses can often be temporary, depending on the type of market in which they are traded.
Obviously, trading short naked puts is a high risk strategy that can result in significant losses - a critical factor to keep in mind when considering such positions. But as Tom and Tony discuss on Market Measures, research shows that such losses can ultimately result in gains, and often do.
The Market Measures team presents some interesting data from the last 10 years of S&P 500 data that helps reinforce this concept.
Using SPY trading data from 2005 to present, a recent tastytrade study examines what happens to a 16 delta short put position that is executed on the first day of each month using closest to 45 days to expiration. Next, the study calculated the frequency of losses exceeding 1x, 2x, 3x,4x, and 5x the initial credit taken in from the put sale.
An example of one such trade from this 10-year data set is depicted below::
Given the study’s parameters, there were 129 total trades executed - the above shows the most recent single trade.
The 129 trades from the study were then aggregated into categories separated by the number of times the trade reached a loss equal to 1x, 2x, 3x, 4x, or 5x the initial credit. Included in the data is not only the number of times one of the 129 trades reached a loss to each of those specific degrees, but also how many of those trades ultimately ended up making a profit.
For example, the slide below illustrates that of the 129 total trades, 33 (or 26%) reached a loss that was 1x the initial credit. However, we also observe that of those 33 that suffered 1x drawdowns, 26 of them climbed back to profitability before expiration.
The entire grouping of results is shown below:
As one can see above, a large majority of the trades that hit a loss equal to 1x or 2x the initial credit bounced back to profitable territory by expiration. That means 37 of the 51 trades in these two categories did suffer a significant loss at one point during the trade life cycle but ended in the green.
The next grouping of results from the study does an even better job of illustrating how patience can truly pay off when trading short puts. Using the same parameters and data as detailed previously, the following information reveals how the total profit of 7 different trade management strategies run as separate scenarios throughout all 129 trades and the associated results.
The first portfolio management strategy involved leaving all of the trades on from execution through expiration while the second was a 50% active management style in which trades that reached 50% of maximum profit were closed.
The other five strategies, and associated profit and losses, involved removing the trades when they reached a loss equal to 1x, 2x, 3x, 4x, or 5x the initial credit.
So for example, the 1x strategy closed every trade that reached a loss equal to the 1x the initial credit - meaning no trades were allowed to lose more than that and trades that experienced less than a loss equal to 1x the initial credit were left on through expiration. The 2x, 3x, 4x, and 5x scenarios were run in the same way per category.
Amazingly, the returns from all 7 strategies were positive, although varied, as shown below:
While the first strategy, which left all trades on until expiration, produced the highest level of profit, it also suffered considerable a considerable drawdown at some point during the scenario.
On the other hand, the 50% profit management strategy and the strategy removing trades after reaching a loss equal to 2x the initial credit resulted in slightly lower profit levels, but considerably lower drawdowns.
For a full take on this extremely market relevant topic, we recommend watching the full episode of Market Measures from August 26, 2015 at your convenience.
Additionally, we encourage you to follow-up with any questions, comments, or suggestions.
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