We are mainly premium sellers. This is because of the edge we get from Implied Volatility (IV) consistently overstating the expected move. Shorting premium also places Theta (time decay) on our side. This means that we are often short premium. We have previously discussed the benefits of carrying short Deltas as a hedge against our short Vega but are there some other ways we should consider hedging our short premium trades?
The majority of losing short Strangles (30% at expiration) lose to the upside (60% vs 40%). That has us looking to add long Deltas in addition to our short Deltas for those Strangles. A table of possible position pairing with a short Strangle was displayed. The table included the options position, what it hedged against and the thought process behind the hedging position addition. Our study was conducted in the SPY (S&P 500 ETF) using data from 2005 to the present. We sold a 30 Delta Strangle and added a hedging position. The four hedging positions were a short 16 Delta Call, Long 16 Delta Call, Long 16 Delta Put and a long 30 Delta VIX Put. We then compared how each pairing worked in all environments and also when the short Strangles resulted in losses.
A results table compared the win rate, average P/L and largest loss in all environments. The table showed that the only hedge that was used in this study that exceeded the short Strangle P/L alone in all environments was the added short Deltas of the short Call. A second results table compared the strategies when the Strangles were losers to the upside. In this case those looking to hedge upside risk are best off buying a further out-of-the-money (OTM) Call. Buying downside protection or volatility protection did not help at all. A final results table compared the strategies when the short Strangles were losers to the downside. The table showed that when it came to hedging against downside risk and Vega risk, all strategies except for the long SPY calls helped the short Strangle position.
Tom noted, "Nothing works as well as the default move which is to be short premium, short Delta in all environments. It gives you a certain amount of protection and it helps your returns."
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and other information we gleaned from the results of our study on different methods for hedging short premium positions.
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