Last few weeks, I have been doing analysis on lots of option strategies on past 12 years data. This article aims to explain one such analysis on Short Strangle option strategy. Starting with basics of selling a Strangle, I aim to explain how has Strangle performed in the past 12 years, what are the risks involved and what market conditions are suitable for playing this strategy.
Strangle is an option selling strategy which involves selling an OTM call option and an OTM put option. It benefits the most if the underlying ends within a range by expiry. Maximum profit is the amount of premium collected by selling the options. The loss on this strategy is unlimited.
Let say Nifty is at ~9850. We can make a Strangle by selling 9500PE and 10200CE. Below is the payoff diagram for this strangle. If Nifty expires between 9500 and 10200, the trader will keep the entire premium. If Nifty moves outside this range, traders can suffer unlimited losses.
Strangle is one of the favorite strategies of option sellers particularly in index options like Nifty as the index does not give very large moves in a short frame of time. Thus, the trader ends up collecting all of the initial premium for most of the time. The data says ~85% of time , strangle writers make profit. The critical question here is, how good is the 85% win rate ? Is the risk worth it ?
To answer our question, I will present my analysis of selling strangles in the past 12 years i.e. from 1 Jan 2008 to 8 April 2020. This duration has seen a wide variety of markets including 2 major crashes (2008 & 2020). So the data should be good enough to give a solid idea of how strangle performs as a strategy.
Strangle setup for analysis
I have used the following setup to analyse strangles:
- Nifty is used as the underlying.
- I have used 1 lot on the call side & 1 lot on the put side. 1 lot is assumed to have 75 units throughout the period.
- Options with monthly expiry are chosen to set up the strangle.
- Strangle is entered 27 days before the expiry.
- Strangle is taken till the expiry. So no stop loss or profit booking before expiry.
- Strangle is formed by selling OTM options 5% away from the spot price on both Call & Put side. For example, if Nifty is at 10000, 5% of 10000 is 500, Strangle is formed by selling 9500PE & 10500CE
- Analysis is done for monthly expiries lying in between 1 Jan 2008 and 8 April 2020
12 years PnL diagram
Please zoom-in to the picture if it is not visible properly.
Key points to note:
- X -axis represent the year from 2008 to 2020
- Y-axis is the Pnl from -50,000 to 2,00,000
- Strangle gave a net profit of ~60,000 in the past 12 years. Since the margin required to sell 2 lots of Nifty is ~1.5L, that is ~40% return in 12 years (not compounded). Does not feel like high enough return for unlimited risk taken with this strategy. Note, one can get ~6% per annum extra return, if they use liquid bees as collateral for margin money.
- Strangle has been consistently giving profit from 2010 to 2019. This explains a lot why option sellers might be booming in this period. Strangle gave ~140% return till before the crash of 2020.
- 1 bad month in March 2020 due to market crash took away ~8 years of profit. The PnL came down from ~2.1Lakh to ~60k.
- 2008, 2009 & 2020 have lots of ups and downs. These are the times when the market was highly volatile. Clearly strangle should not be played in high volatility.
Net returns: Rs. 59576.25
Total trades taken: 147
Number of profits: 124
Number of loss: 23
Max drawdown: -155178.74999999997
Top 5 profits: [23385.0, 22860.0, 16203.749999999998, 15993.75, 12217.5])
Top 5 losses: [-155178.74999999997, -64811.25, -42761.25, -33225.0, -16586.25])
Average return per trade: 405.2806122448981
Sharpe ratio: 0.4055599174704976
Key things to note:
- 124 wins out of 147 trades taken. That translates to ~85% win rate.
- If you see top 5 profits and top 5 losses, ~23k is the max profit. But the max loss is ~1.5L .This one loss is enough to take down years of returns. Thus you see the curse of unlimited risk strategy. You will win 85% of times, bit one unfortunate month and you have lost most of it.
- Sharpe ratio is the measure of how good the strategy is. Any strategy with Sharpe ratio greater than 2 is considered good. Monthly strangle with OTM options 5% away from the spot price has a sharpe ratio of 0.4 , which is not good at all. I have tweaked around different configurations, but could not come up with a good enough sharpe ratio for this strategy.
I have done analysis of returns in different market volatility. Volatility is tracked using INDIA VIX index. This analysis will help us understand that in what market conditions has strangle performed good and in what conditions we should completely avoid it.
Below table analyses the returns in different VIX buckets. VIX bucket tells what was the INDIA VIX at the time of entry of the strangle. For example, a VIX bucket of [10, 14] tells that when strangle was entered, the VIX was in range [10, 14]
Key things to note:
- Strangle performs with high success rate and net positive PnL when VIX is < 20
- At VIX >= 20 , the win rate has come down, or the PnL is negative for most of the cases.
Strangle has a high win rate but few losses can take away years of profits. If one wants to sell strangles, keep following things in mind:
- Turn it into an iron condor. This will make it a limited risk strategy. Know more about risks of selling naked options here.
- Use adjustments when the market is breaching the range of strangle. Learn more about adjustments here.
- Avoid the high VIX markets to sell a strangle.
If you wish such analysis for more option strategies, please let me know in the comments section. Please subscribe to my blog and follow me on twitter to get all the latest updates.
Learn when to buy or sell a straddle in this blog.