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I sell mostly strangles/straddles given a positive VRP (IV/RV), I rarely buy options as my research has shown they are only profitable in the top 2 deciles of volatility expansion. However, they do provide significant downside risk protection for a net -gamma -vega portfolio.
Removing some of that negative skew risk is something I have been thinking about. The standard options for reducing this risk typically are:
1. Gamma scalping/hedging in the underlying
2. Defined risk strategies
3. Relative value portfolios
I have an issue with all 3, or rather, none of them are perfect.
For Gamma scalping, it is always locking in a loss and highly dependant on your delta model, plus engages in a lot of commissions. They do give you the closest thing to a variance swap payoff, which is what we want. But if that is the case, the friction in general needs to be lower.
Defined risk strategies, they do reduce your margin. And the ratio you reduce your potential profits to the size of your tail risk protection still ends up leaving you potentially 3x to 5x + losers compared to the premium you harvest. Even more, substantial if you do not go all the way to expiration.
Relative value portfolios where you buy and sell volatility in equal proportions, across multiple products is probably the most realistic solution. Although in this environment were, you may have negative VRP but still in high IV percentiles at the same time; it is hard to find targets. You are also going to need much more sophisticated weighting for your options as simple 1:1 won't fly. Probably vega weighting or theta weighting depending on if you expect a proportional or absolute change in IV vs. RV relationships. This model adds another layer of complexity to the strategy, though it would give you protection and the potential for convex outperformance on 'black swan' moves.
In the current conditions right now, I have relegated myself to a combination of purchasing units and offsetting that risk with some underlying futures positions. Units are very far OTM options that are hard to price because option pricing models and greeks become more erratic the farther from ATM you are. These sell at lottery ticket prices more than IV/distribution based pricing. They also have massive convexity if they ever do become ATM.
I usually do about 10-15% of the total net exposure I have in units for a specific sector or underlying. This method is much cheaper than going full iron condor/butterfly with vast wings, which are synthetic straddles/strangles because those units are 'overpriced' compared to the options your selling that would be price 'normally.' It cuts into your profits much more and increases that negative skew outcome if you do take a loser, even if it is risk defined.
I do not think my way is best, as you are still severely exposed. However, in this market environment, it is difficult to offload some of those risks cheaply. Either through diversification (things went to 1, with precious metals and energy are playing follow the leader with SP500 or vice versa), and most products had a massive vol spike then crush which leaves you in a kind of no man's land for a lot of products to sell or buy vol. This environment leaves defined risk spreads not paying you enough, and naked spreads with more risk than usual.
I am interested in this communities thought on the following
Do you guys ever use the underlying to hedge risk, or buy options?
Does anyone here ever buy options to get long vol?
How do you manage your portfolio risks? On greeks, on margin, on x% shocks?
I've been following this thread for many years and have added a few comments here and there over the years. What stands out to me is that selling options far OTM is a losing proposition in the long run. Those supposedly rare black swan events come up much more frequently than would be expected by random chance (e.g. fat tail risk). Initially I was quite intrigued by Ron's idea and it seemed almost too good to be true. I think all traders are secretly hoping that the "holy grail" of trading is out there, and I see that many of the first time readers of the thread often posted with these type of comments having their interest peaked.
The premise was that as long as you just held onto your naked option position -- in spite of paper losses of upwards of 80+% -- that eventually the trade would return to profitability. You just needed to have the correct level of IM on the account which was around 4x originally but then later it became 5x or 6x or even more. This was because supposedly there had never historically been a drop in the S&P 500 of over 20% in X number of trading days. So you just hold onto the position through the drawdown because you still have time for the market to bounce back and recover because it never went in the money. You just needed to be able to ride out the margin calls and "paper losses". Much of the original research and tweaks were trying to optimize what margin IM number was needed to ride out these trades based on historical data and backtesting.
The original strategy was changed fairly significantly after massive losses in August 2015. Now it was using ratio spreads instead of naked put options. The idea was to buy even more options that were even further OTM than the number being sold to protect or hedge against the massive unexpected drops and spikes in IV that are the death knell for option sellers. So something along the lines of short 2 options at delta .03 and then long 3 options at delta .01
This new strategy was also tweaked and revised over the next couple years including the IM that needed to be held to avoid taking massive losses by going on margin call. February 2018 was another particularly ugly month with large losses but some say they were able to avoid trading then because they foresaw the volatility coming. Now fast forward to 2020 and I would venture that anyone still using the strategy blew up their account, again...
I was particularly interested to read that @ron99 started trading the exact opposite type of trade this year in 2020. He was now buying large numbers of far OTM ES puts and then continually rolling them down. I'm sure there were very nice profits made if the trade was successfully exited at the bottom and I realize this was a situational trade based on market conditions. But still, in many way this is the ultimate irony to me, and perhaps to many others that have also followed this thread for some time... What started out so many years ago as a set it and forget it strategy of selling naked far OTM puts had come full circle to now buying those exact same far OTM ES puts in large numbers and trying to time/predict the market looking for a drop.
I agree. Selling far out of the money puts is a slow grind way of making money, and every 2 or 3 years you take a hair cut that negates any gains.
I have done much better using order flow with day trading, and with much less risk and concern.
