We say it often, “trade small, trade often”. We say this because, thanks to our studies and experience, we believe that the expected move according to the Implied Volatility (IV) of an option is most often greater than the actual move. The Skinny on Options Data Science from May 13, 2015, “Implied vs Actual Volatility” explains this well. A more recent segment from April 28, 2016, “Simulating Carlos Monte’s Trading Account” explained Monte Carlo simulations. Dr. Data combined the two concepts to answer a question we are frequently asked, “How much capital do I need to trade the tastylive way?”. He’s here with his tools of Data Science and for an added kicker, he demonstrates why selling option premium beats “Buy and Hold”.
A Monte Carlo Simulation is a mathematical technique that allows researchers to account for risks by displaying a range of possible outcomes. From the possible outcomes, we can arrive at probabilities -- e.g. the probability of losing half or doubling the account size. So if we want to use the tastylive favorite 1 Standard Deviation (SD) Strangles how much capital do we need? Mike ran a series of Monte Carlo scenarios. The SPY 1 SD Strangle closest to 45 days to expiration (DTE) was sold. The trade was either managed at 50% of max profit, exited at a loss if it was 2x the maximum credit received or held it to expiration. We started with a $4000 margin account and continuously placed 1 trade over the course of a year but stopped if we hit the margin call level of around $3500. We compared this to a “Buy and Hold” strategy.
A graph displayed the winners and losers from selling the Strangles. There were many more winners than losers, although a few of the losers were large outliers. This was the sample source in the Monte Carlo simulations for the Strangle performance. A table showed three different accounts, one starting with $4000, one starting with $5000 and the third with $6000, the percentage of times the Monte Carlo simulation showed the account dipping below the $3500 margin call area at anytime before the end of one year and showed this for both the short Strangle strategy and “Buy and Hold”. A second table showed what the return was for each account size and each strategy for the 75th percentile, 50th percentile and 25th percentile as well as the average return for each. Selling Strangles has clearly better results and a $6K account clearly has its advantages.
For more on the strategies compared here see:
Market Measures from January 22, 2015: “Active Trading vs. Passive Investing”
Market Measures from September 22, 2015 “Strangle Checklist”
Watch this segment of the “Skinny on Options Data Science” with Tom Sosnoff, Tony Battista and Dr. Data (Michael Rechenthin, Ph.D) "for a spectacular piece of research" and a better understanding of both how much capital is needed to trade the tastylive way and why it beats “Buy and Hold”.
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