In our quest to understand trading options for income, we often consider various methods for adjusting positions when being challenged. In this article, we look at adjustments to short Strangles.
A short Strangle is an undefined risk option strategy in which an OTM (out of the money) Put and OTM Call options are sold concurrently, and within the same option chain. It is considered an undefined risk because the max loss cannot be defined (it is uncertain).
Common approaches to adjusting short Strangles fall into two groups: adjusting the challenged side, and adjusting the unchallenged side. For the former group, there are three adjustments to the challenged side: first, rolling further OTM to the same level of POP (probability of profit) as the initial position within the same option chain (we'll call this FOTM for Further Out of the Money); second, rolling out to the next month at the same strike as the original position (we'll call this FOIT for Further Out in Time); and third, rolling further OTM and to the next month (a combination of the first two; we'll call this COMBO).
For the latter group, there is only one adjustment to the unchallenged side: to roll further ITM to the same POP as the initial position within the same option chain (we'll call this FITM for Further in the Money).
The question is: which type adjustment results in a overall higher P&L?
Tasty Trade recently tested two ETFs (SPY and GLD) over a 2-year period. The test consisted of placing a 1 SD (standard deviation) short Strangle (approximately 16 delta each leg) within a monthly with approximately 45 DTE (days till expiration). An adjustment was made when the challenged side reached 30 delta.
The results: for both SPY and GLD, simply adjusting the unchallenged side resulted in the highest P&L, while making no adjustment resulted in the second highest (still beating adjustments to the challenged side). The COMBO came in third and matched the percent winners of the unchallenged side.
In conclusion, the above test provides a strong argument for simply applying adjustments to the unchallenged side. However, the FOTM adjustment simply reduces the loss; it doesn't avoid it. A better approach would be to increase the size of the adjusted position to completely offset the loss, or result in a gain (thus avoiding any loss).
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