After trading “defined risk” model portfolios (e.g. iron condors and iron butterflies) on this blog for the last two years, we will commence our first model portfolio using “undefined risk” option strategies in FY2017.

What do we mean by “Undefined Risk”?

“Undefined risk” does not mean unlimited risk. We can always limit our risk by setting a loss threshold where we close our trade. What it means is that we do not buy any insurance options to limit our maximum loss and margin required for the options we sell. For example, the undefined risk equivalent for the iron butterfly would be the short straddle. We SELL ATM puts and calls for both strategies but we DO NOT buy puts and calls to limit our margin required and maximum loss for short straddles. The risk graph of the short straddle is shown below:

Short Straddle Image

The most important thing to bear in mind with undefined risk trades is that the margin required is NOT fixed. Therefore you must have sufficient cash/stock in your trading account to cover margins which can increase substantially when IV spikes or when OTM options become ITM. For example, if you sell an OTM 4800 put when XJO is trading at 5375, the margin required for this trade will be around $480 as shown in the ASX margin estimator below:

Margin-OTM

If XJO falls to 4800 and the IV goes up to 30, then the margin required for your 4800 put will be similar to what the margin is for the ATM 5375 put as shown below:

Margin-ATM

Using the above example, if you sell 5 contracts of naked 4800 puts, you will only need $2400 ($480 x 5) to cover margins initially but around $19,000 if the margin increases to $3800 per contract. If you only have $10,000 in your account, you will receive a margin call or have some of your positions liquidated by your broker if you do not have sufficient collateral to cover margins. As margins are not fixed, undefined risk trades are more suitable for people who have larger trading accounts and who are also not pursuing aggressive portfolio returns. If you had a $10,000 account, you might be better off selling 5 contracts of 4800/4600 put spreads as the margin is always fixed at $10,000.

So why should we do undefined risk trades?

Some of the benefits include

  • Keeping more premium per contract as you do not have to buy any long options
  • Shorter time to reach profit target as time decay on the short options is not offset by time decay in the long options
  • Paying less brokerage e.g. there are 2 legs for short straddle vs 4 legs for iron butterfly

My muse for this undefined risk model portfolio is Jane, who was also my muse for the Vanilla Model Portfolio in 2012. Jane is now 59 years old and is looking to retire next year. She has over $300,000 of her portfolio in fixed interest. With the RBA cutting interest rates, she is concerned that she will not get sufficient income from her fixed interest portfolio to live comfortably when she retires. She would be very happy if she could use options to generate an additional 2-3% per year to this portfolio. She is also not prepared to take a lot of risk either, so she is only going to trade with very small position sizes. She has over $100,000 in her stock portfolio which can be used to cover the margin required for her option trades.

We will use System Quality to help us choose which undefined risk strategy to trade.  The System Quality of the three defined risk model portfolios that had given us positive returns are shown in the table below:

SQR of IC and IB

The trading system with the highest System Quality Ratio was the Iron Butterfly, so we will try trading Straddles in our first undefined risk model portfolio.  DTR Trading has also done some excellent back testing studies on straddles using the SPX.  I found a couple of straddle strategies that I liked which are:

  • the 38 DTE Short Straddle with a profit target of 10% of premium collected and a loss threshold of 25% of premium collected, and
  • the 38 DTE Short Straddle with a profit target of 25% of premium collected and a loss threshold of 25% of premium collected

I calculated the System Quality for these two strategies and compared the results with the 20 delta iron condor which we used to trade our Mark III model portfolio. The results are summarised in the table below.

SQR of Straddles

As we can see from the table, the system expectancy and system quality of both the straddle strategies is higher than the 20 delta iron condor. Both straddle strategies have the same risk (i.e. 25% of premium collected). The first strategy has a higher win rate, system quality and shorter duration, but the second strategy is more profitable (i.e. higher system expectancy). I would also like to try taking profit at 15% which is similar to our Iron Butterfly model portfolio which we traded in 2015. For our first straddle model portfolio, I will open the trade with 3 contracts but close 1 contract each when a profit of 10%, 15% and 25% of premium collected is reached. Like previous model portfolios, we will open our trades after the RBA meeting which is normally held on the first Tuesday of the month.

The above is summarised in the Trading Plan for the first XJO Straddle portfolio. As the back testing results have shown a high winning percentage in all IV conditions, we will place a trade every month regardless of IV Rank.

I opened the first trade for our Straddle model portfolio, a July’16 straddle, on 10 June 2016 which was 41 DTE. XJO was trading at 5308 so we sold our straddle at 5300. I will provide an update for this XJO Straddle model portfolio after the July trade is closed.

Disclaimer: This post is for educational purposes only and should not be treated as investment advice. This strategy would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek investment advice if required.

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