With volatility in the markets trending higher in recent weeks, you may be strategizing about trading approaches and tactics that could be suitable for the current environment. On the other hand, you might also be focusing on risk management - ensuring that your portfolio behaves as you expect it to, no matter the conditions.
If either of those are true (or both), a previous installment of The Ryan & Beef Show should provide your brainstorming effort with a nice turbo boost. While this is an archived episode, the research presented on the show is particularly hard-hitting when considering the current trading environment.
Titled "Diversifying a Short Option Portfolio,” the show not only provides insight on approaches that can help with short premium portfolio diversification, but it also helps illustrate how diversification can help reduce volatility in your portfolio’s P/L.
In order to drive home these points, the hosts of Ryan & Beef compare the performance of two different short premium portfolios. One that is relatively plain vanilla, selling strangles in only SPY, and the other which involves selling strangles across four diversified asset classes (equities, metals, currencies, and bonds).
The premise behind the selection of those four underlying markets was the fact that none of them are highly correlated to one another. As you can see in the graphic below, only the metals representative (gold) and the bond representative (TLT) showed a noticeable correlation - and even that one wasn't remarkably high:
Featured on the show is an expansive research study conducted by Frank, who joins Ryan on this episode to share the details. The study was designed to backtest the respective trading approaches (plain vanilla vs. diversified) and then to analyze the results.
Frank’s two-pronged backtest was therefore designed according to the following parameters:
Utilized historical data in 4 symbols from 2008 to 2017
Included four diversified underlying symbols/markets: Equities (SPY), metals (GLD), currencies (FXE), and bonds (TLT)
Backtested short strangles (16 delta) with on average 45 DTE across two different strategies:
Strategy 1: Sold 4 strangles in SPY
Strategy 2: Sold 1 strangle in each of the four markets (SPY, GLD, FXE, TLT)
Managed all trades at 50% of credit received
As you can see in the graphic below, the results of Frank’s backtests show some rather interesting results:
Most importantly, we can see from the above data that the two approaches produced nearly identical win rates, and roughly the same average P/L.
It’s the next piece of information in the chart that really illustrates the big differentiation between the two. That is of course is the “standard deviation of the P/L” metric, which basically speaks to the volatility of the P/L.
According to this rather expansive study, the volatility of the P/L for the diversified approach was significantly reduced compared to the SPY-only approach. This finding is clearly linked to the fact that the diversified approach included four underlying symbols that don’t share a high degree of correlation.
This study therefore helps illustrate the power of diversification, and how it can help transform the risk profile of two approaches that may seem quite similar superficially, but are quite different in practice.
If you’ve found that your own portfolio’s P/L has fluctuated extensively with the uptick in equities volatility, it’s possible the information presented on this installment of The Ryan & Beef Show may help you in adjusting your approach such that it better matches your preferred risk profile.
If you want to learn more about the diversified approach to trading premium, a new episode of Options Jive pairs well with this theme. We hope you’ll take the time to review both episodes when your schedule allows.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.