The Risk of Return

Yesterday, I published a trade idea in the Materials ETF $XLB that called for selling out-of-the-money (OTM) naked short puts and calls.

This strategy is commonly called a Short Strangle. And for this particular Strangle with April options, we collected around $125 per one-lot.

This is a type of trade I like to put on when implied volatilities are rising in the marketplace and trading action is sloppy, sideways, or down.

A reader emailed me this question:

$1,253 required to make $112 appears expensive to me. $112/$1253 for around six weeks returns around 10%? Does your broker require less margin?

Here’s the thing about short premium plays in general and short strangles in particular: we have a high probability of winning.

The odds are in our favor. That’s the upside. But the downside is, when the odds are high that we’ll win, the profits obtained in these trades are usually pretty small in terms of the capital invested to put the trade on.

And this makes sense. If it was incredibly cheap (in terms of buying power) to put on a trade that has a 90% chance of winning money, everyone would do them —in size.

But there is no free lunch.

In addition to the buying power required to hold naked short options, we need to manage our risks closely. Because in the lower probability scenario where we lose money, there is tail risk (meaning small but not insignificant risk) that could result in us suffering a far larger loss than we intended, far in excess of any potential gains we may have earned if the trade went our way.

And that’s why brokers require us to hold as much margin as they do for naked options.

Again, there is no free lunch.

If we like this trade, but these risks make me uncomfortable or I just don’t have the available buying power to hold this trade, I could always purchase cheap, way out-of-the-money long calls and puts against this Strangle to define my risks and lower the margin requirement.

Options gives us options.

Trade 'em Well,

Sean McLaughlin
Chief Options Strategist
All Star Charts, Technical Analysis Research