We have previously discussed how to manage losing trades in Delta Neutral strategies such as short Strangles. This segment focuses on short Puts which is more of a directional strategy. There are three choices for managing a losing trade. We can close the trade or reduce the size. We can add offsetting Delta (either through options or the underlying). We can add duration by rolling. Does rolling short Puts that are losers turn them into winners?
Tom explained, “If you're talking about inflated fear and Volatility Skew, where are you going to get the most inflated fear? You’re gonna get it in Puts. Also, you get the most inflated fear in downside moves. So if you're interested in a strategy where you have naked options most people prefer to sell Puts, and sell them into down moves where basis price is cheap and option prices are expensive.
Our first study was conducted in the SPY (S&P 500 ETF) from 2005 to the present. We sold the 1 SD Put. We chose the option expiration cycle closest to 45 days to expiration (DTE). We held the positions through expiration. A table displayed some of the results. Our short Puts were tested (meaning they were in-the-money at some time before expiration) 14% of the time, and although 53% of those tested expired profitable the average P/L for those tested Puts was -$40.
Our second study looked into rolling the tested Puts. If there were more than four weeks to expiration we did nothing and held the trade to expiration. If there was less than that we rolled out to the next expiration using the same strike. We rolled only once to keep the study simpler. A second results table showed that rolling to the next monthly cycle the “tested” puts produced much better results than taking no action. The average P/L went from a negative -$40 to a positive $49 and the win rate rose from 53% to 82%.
Tom added, “This is what trading is all about! This is what strategy is! This is how you create value to finance. This means that by rolling the Put you lower the number of losers in all the 1 SD short Puts from 14% down to 3%-5%, and the rest are winners.”
For more information on Rolling see:
Market Measures from February 9, 2016: "Rolling Puts"
Options Jive from May 18, 2016: "Defending Trades | Rolling to Increase Probabilities"
Best Practices from November 10, 2016: "Defending Trades Gone Bad - Rolling"
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the exciting takeaways and the results of our study on rolling tested Puts and how doing so, dramatically increases our P/L and POP.
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