The majority of trades we do here with All Star Options tend to be directional in nature. And why not? We’re leveraging best-in-class technical analysis to give us an uncommon edge to participate in emerging and/or continuing trends. And if we know anything as Traders, we know that if we have an edge, we should attempt to execute against that edge as often as possible.

Meanwhile, I recognize there is an entire cottage industry around “selling options premium” and for good reason — it works! That doesn’t mean it always works nor does it mean it’s easy. I just don’t like to make it my only thing.

That said, one of my favorite strategies is to sell premium via Short Strangles.

A Short Strangle is a delta-neutral options spread that consists of two legs: a naked short put position and an equally-sized naked short call position. Both option strikes are typically out-of-the-money. Here’s how a typical PnL graph for a Short Strangle would look:

It should be noted that due to the naked options, this type of spread will require margin and we have theoretically unlimited risk if the underlying were to take off in either direction on us.

The first order of business when putting these spreads on is to seek out instruments — preferably ETFs or large cap stocks — that are experiencing elevated implied volatility (IV). When IV is high, options premiums are elevated because market participants are bidding up the cost of calls and puts either to hedge some perceived risk or to take advantage of a speculative opportunity. Now, there is no precise IV value I look for. I just want the IV for the stock today to be in the upper end of the range of where it’s been over the past 6-12 months. High premiums offer us an edge as volatility tends to mean revert and when that happens, the high volatility options we sold at higher prices tend to see their value erode (a great thing when we’re short!)

When I’ve selected the right instrument, my initial instinct is then to identify the 25 delta strikes for both the calls and puts. But that isn’t always the strikes I end up selecting. More important to me is that the strikes line up just beyond obvious levels of support and resistance.

For instance, here’s a recent Short Strangle trade I put on in $XLI October options:

The horizontal lines represent the short call (107) and short put (98) strikes I had chosen.  Notice how those strikes corresponded nicely with overhead resistance and downside support? It just so happened that both of these options were each sporting approximately 25 deltas. It’s amazing how often that ends up being the case. (Market makers are no dummies!)

My profit goal with Short Strangles is always to keep 50% of the original premium collected. Let’s say I collected a $3.00 credit for the spread on Day 1. Once I can buy-to-close the spread back for a $1.50 debit or less, I’ll do so, booking my profits and moving on to the next trade. When I put this $XLI trade on above, it had approximately 6 weeks until October expiration. But it only took me two weeks to cover this spread at my profit target of 50% of the original premium collected in the trade.

Why do I cover at 50%?

Because once the spread loses value (a good thing when we’re short it), we start getting to a point of diminishing returns. Let’s say that spread I sold for $3.00 is now only worth 75 cents. I’ve got a winner on my hands and that’s nice. But now I can only make 75 cents more if I hold all the way to expiration and the options expire worthless — but I’m still holding the entirety of the theoretically unlimited risk! That math doesn’t make sense. It doesn’t make sense to get paid so little to hold so much risk. So I’d rather just cut the trade loose once I’ve earned 50% of the original credit and then move on to new opportunities with less risk.

On the risk management side, I know a lot of people who trade Short Strangles like to move strikes on the winning side to bring in more credits to defend a losing position and that’s fine if you want to put in that kinda work. But for me, I chose my short strikes for a reason (because they were significant support & resistance levels), and therefore I’m going to hold the trade and trust its going to work as long as the stock or ETF stays inside those strikes. But if the underlying moves outside those strikes, why defend it? Clearly my reason for being in the trade (a stubborn range) has been violated and therefore my thesis is busted. I’m not going to defend this trade and argue with the market. No, I’m just going to close the trade, book the loss, and move on. Let it be somebody else’s problem.

I always try to have some strangles working in my portfolio most of the time. They are a good counterbalance to a portfolio of mostly directional trades. When markets start grinding sideways and breakouts are failing left and right, it’s nice to have some delta neutral trades like Short Strangles on the books that profit during sideways churns and offer some much needed profits.

Do you trade Short Strangles? If not, why not? I’d love to hear from you.

@chicagosean

Indian markets are going through volatile times. What makes it so is a tug of war between DIIs and FIIs. Domestic institutions buy in the morning while foreign institutional investors sell in the afternoon, making it a non-trending market with a bearish bias that comes with a lot of noise.

From a technical standpoint, from the last decent correction, Nifty advanced from 14151 to 18604.

Now the 0.6180 Fibonacci retracement support is placed at 16,702. As the theory of technical analysis stresses more on the importance of the golden ratio of 0.618, so are markets pausing from the long downtrend around this mark.

If the 16700 mark is broken decisively, it will open the doors to further correction towards the levels of 16,200-16,000. Keep in mind, 16,000 was the same mark where the markets broke out of a tight range-bound market.

So far what has helped this correction was fall in crude oil, a leading indicator for the global market. In addition to that, we have the rise in US dollar and Japanese yen. Both are considered safe havens and rise in periods of uncertainty. Rise in the dollar often has a negative correlation with equity markets in India. Similarly, the yen is also considered a safe haven asset and rises in times of panic. Thus, Gold, Dollar, and Yen have a negative correlation with equities. In fact JPY/INR rose by 3% in 3 days. Which is significant for any currency.

Presently, these indicators are near the resistance.

Persistent weakness in gold prices and decline in dollar index suggests concerns of omicron virus are blown out of proportion and markets can correct that in the short term.

On the weekly charts, for first time Nifty is testing the support zone of its super trend. If respected, then the markets can bounce back!

Ratio charts-

Nifty/Gold is currently holding on to good support. Nifty/gold is trading at 9.65. If it goes below 9.40 we can expect a further correction in markets. If there is a decisive close above 9.90, we can expect some short covering the markets. From an Intermarket analysis point of view, gold and equities have a negative correlation.

Nifty relative to Dow Jones Industrial is at a strong support level too. After retesting the breakout zone, the ratio is now inching higher as can be seen in the chart below. This ratio shows the strength of the local market against the Global Markets. Indian Markets are weak if it goes below 0.50, strong if it goes above 0.55.

This is what the charts say, but let’s see how it unfolds!

There is no perfect investing system. But there are unlimited effective ones.

Diversification has been touted as a key component of a proper investment portfolio for decades by the financial industry. But asset diversification misses the point entirely. The purpose of diversifying a portfolio is to prepare for varying outcomes.

Owning different assets won’t do that. Correlations rise during periods of volatility. So you get underperformance when markets are strong, and not a corresponding amount of outperformance when markets are bad.

So what can you do?

Easy … diversify your signals, not your assets.

Any investment process is going to go through periods where it is out of sync with markets. A pure trend following system is bound to have whipsaws. Momentum-following systems can give buy signals at tops and sell signals at bottoms.

By recognizing the flaws in one system, you can develop another system to help offset the negative effects of those flaws. Then it becomes a decision of how much exposure you want to one system versus another. Or in reality, exposure to a variety of different systems.

Let’s look at an example of a trend following system combined with a momentum system.

• Trend System: Long SPY or Cash. 100% in SPY above the monthly pivot point, 100% cash below it. Buy and Sell signals are based on a specified period of consecutive daily closes above or below this level.
• Momentum System: Long S&P 500 Sector ETFs based on a weekly RRG chart, using SPY as the benchmark. Stop losses based on a percentage decline from purchase price.

(These are simplified versions of actual investing systems that we use at IronBridge Private Wealth.)

Let’s first look at a chart of a long/cash trend system using SPY and pivot points.

This chart shows us a few things:

1. The green shaded areas are when the system is long SPY. Un-shaded areas are when it is in cash.
2. The system is designed to be in most of the uptrend, while avoiding the major bear markets.
3. During periods of volatility, this system experienced whipsaws. These whipsaws can result in both underperformance relative to the S&P 500 index, as well as experience losses in the portfolio.

By itself, this is not a bad system. However, what if we could combine this system with another one that didn’t reduce exposure on the smaller pullbacks?

The goal of a complimentary system to the strategy above would be to maintain exposure during the times when the trend system was in cash. The un-shaded areas above did not result in major market declines. After all, there are lots of 5-10% pullbacks over time, and many of them are quickly recovered.

Knowing what you’re trying to achieve, you can then create a system that is aimed at staying invested during those pullbacks. It could be created using RRG charts, moving averages, other trend markers…the options are endless. Plus, instead of having an exit based on that signal, you could have a simple stop-loss that is likely to not be triggered during these declines.

Your buy and sell signals in the second system are both independent and complimentary of the first system. And they are simple enough to be repeatable over time. You could even layer in ways to create potential outperformance in the uptrends to further enhance the effectiveness of the combined systems.

You can still diversify your asset exposure in addition to diversifying your signals. Simply apply the same rules to US stocks, international stocks, bonds, crypto … you name it.

But before implementing any type of investing system, you must be able to back-test it. This accomplishes a few important things:

1. It forces you to create rules. You cannot back-test without specific buy/sell criteria.
2. It allows you to objectively identify flaws. You can hope a system works in various market environments, but you won’t know for sure until you see the actual data.
3. It allows you to test the effectiveness of complimentary strategies. Again, you don’t know if it works until you see it.
4. It helps eliminate the biggest source of risk: YOU. Getting your emotions out of the process is the single most important aspect of any system. You can’t predict the markets, so stop trying.

Strive to create disciplined and repeatable investment processes, based upon diversifying your signals.

By doing this, you can then create an effective system for you or your clients in any market environment.