My advice, and this is probably better than most will give without trolling you to death is to spend some money and back test this strategy.
I’m not huge on back testing, however I find that if it failed in the past, it’s going to fail in the future. If it breaks even, it’s not worth it, and only if it provides decent profits should you move forward with it – and even then that doesn’t imply live trading.
I say this only because I see issues with short (ratio) strangles at 2% OTM (you mean .48 delta?) with 7 DTE and the rolling strategy you posted.
I’ve never done what you have, but I have done something previously with short strangles with 7-8 DTE in JPY FOPs – I concluded the short DTE is not worth it as an outright trade, they are really only good for short (as in time) hedges against larger option or future positions.
Furthermore, your vega assessment is incorrect, I’ve personally witnessed otherwise. The end of last October and early November saw the Nikkei rally (hard) after unexpected BOJ stimulus. Volatility absolutely soared and it caught me and my position off guard, I had a significant drawdown, and the strategy your suggesting (if ever used previously yourself?) would not be possible.
The lesson here, who says volatility can’t rise significantly while the market rises? It can, it did, and if you model your portfolio for what happened in Japan, will you be trading tomorrow?
You need to say yes. Otherwise, back to the books my friend.
When I first came up with this strategy, I was terrified of naked calls because of two big concerns. The first was the unlimited loss potential that you hear with naked calls all of the time. The second was what would happen if the market rose and volatility rose with it, as you described?
So, I went searching through all of the historical periods where there have been sharp rises in the markets that also came with huge spikes (or already elevated) levels of volatility. I did my best to rank the 50 largest 1 week moves that also was tied to (likely) high volatility. What I found was that about 90% of those moves were after a significant downward event. And the downward event was where the volatility spike occurred. In these scenarios, if the positions had already been opened, then the down followed by the up did not impact the overall position. If you opened the naked calls when the market was already down, then volatility was already high, and you should be in a position to go further out of the money for the same return. Either way, if the market is moving fast down, you have to be really careful about heavy swings in the other direction when opening up a new ratio strangle.
I modeled a lot of this through 2008 and 2009 and found that any opened call positions that may have gone negative due to increasing volatility or spikes up from major down days were more than compensated from the likely loses of the smaller naked put position that was likely deep ITM and rolling out + down. So in situations where calls were taking loses due to increasing vega + bounces, the losses on the puts were diminishing, and overall portfolio position remained balanced.
Where it got interesting were the few days in history where there was a dramatic increase in volatility, a big up day, and there was no previously strong down day. Kind of like the experience you described in Japan. One of these events happened recently - the announcement of QE 3 or maybe it was 4. I think with QE3, the market had already risen volatility because of the end of the previous QE, so was in a tialspin, and when QE3 announced it was a massive bounce. But QE4 was somewhat unexpected and off of no negative news, with a huge swing upward. Volatility did increase, but not above 20 if I recall. It was shortly after this a lot of my options went ITM and had to do the adjustment philosophy.
I hear you on never betting on the idea that the market doens't have a volatility spike and a dramatic increase at the same time. It is this reason which is why I do not trade this strategy on anything other than SPX. The earnings forecasts of the S&P 500 are so well researched that it will be hard to have a volatility spike other than for a downward event. Macro factors like liquidity from the Fed are unknowns that can cause such things. But otherwise, with so much money in the S&P 500 to begin with, the overall volatility of the index as a whole is dimished a bit. There may be situations in the future that disprove the point, but this is the area where it's worth taking the risk.
Again, I come back to position sizing - and making sure that I can absorb increasing vega + a big move against me without receiving a margin call. If I avoid the margin call, I have a library of adjustments to use that buy me time, deleverage, and add to my cash position.
The beautiful thing about options is that time and volatility are infinite. It's about designing a system that can absorb whatever short terms shocks so that you can benefit from the long term infinity of time and market volatility.
