Show notes
Hey everyone, Kirk here again at optionalpha.com and welcome back to the daily call. Today, we're going to be answering the question – "Which option strategy has the highest returns?" Before we actually go into this topic, I think it's important that we talk about the differentiation between returns and volatility in your account. This is something I yet to hear this often talked about and this difference between going after the highest, highest return versus something that has basically low volatility or stability in the portfolio. Imagine two different things before we even start this conversation. Imagine that you have a portfolio curve, so your bank account goes up and down every single day by $5,000. Now, if I just said that to you right now, some of you would think, "Holy cow! That's like all of my account. I could either lose or double my account every single day." Others of you may have said, "Well, that's not that much. I've got a larger account. $5,000 up or down is not a lot of volatility in my account."
But what people don't think about is they don't think about these magnitude of changes that might occur based on what option strategy they trade and most often, people go after an option strategy purely looking for the highest returning option strategy with no context of how much volatility they might go through. Now, I say "might go through" because it doesn't mean that if there's a lot of volatility in your account, doesn't mean that it's a bad strategy. It just means that's the framework of the strategy, that the strategy is a strategy that ultimately is going to create a lot of volatility, but may actually lead to higher returns. In some cases, there's option strategies that we've back-tested that have lots of volatility that ultimately lead to lower returns. It is not a 1:1 relationship, meaning that if you have higher returns, that doesn't mean that you have to have higher volatility or vice versa. I think it's ultimately the context of the trading strategy that you build. But you have to understand these two different components because that is critical to your long-term success.
I say that because what I've often seen people do is get into trading, they start either following our trades or doing trades using the back-tester and our watch list software that we built at Option Alpha. They start getting into trades and executing trades, going after the highest returning strategies and then they realize that those strategies means that you might have in some cases, a down month once or twice and then you might have two up months and then you might have three down months and then four up months. And so, there's a lot of volatility in their account and they just can't mentally handle the stability that's required or the patience that's required to trade through those types of scenarios. We all know that we're never going to have 100% winning trades, but sometimes people come into this assuming that that is the case and they are often blindsided by this up and down framework that happens among the trading strategy.
I think before we even just start this discussion of what has the highest returns, what has the best returns over the long run, we have to understand how volatility impacts that. Now, the good news is that with our back-testing and trade optimization software that we've built which you can check out at optionalpha.com/toolbox, we factor that in. When you run a back-test, you can see how volatile was this account, what was the biggest drawdown, how long did that last and then you can see graphically how your stock performed against the S&P, so that you have an understanding before you even get into that trading strategy, what you might expect going forward in the future. Some people have even emailed me and said, "You know what? I'm looking at a strategy right now and it could return 10% a year, but I might go through a 30% drawdown. I'd rather have an 8% return with maybe a 10% drawdown. That's the differentiation. It's not to say that one is bad or different or better than the other. It's just what type of portfolio curve, what type of framework do you want in your account going forward which is really important.
When we get back to the topic of just what is the highest returning strategies, this is an interesting one because there's obviously not one particular strategy that is the unicorn strategy. Everyone is looking for the unicorn. But there are strategies that work better in different market environments than others which is really important to know right off the bat. On a return basis, what you often find is that you often find the highest ROI strategies, meaning the actual credit received versus the actual amount of risk or capital that you have to put up is generally found in spreads. This can be credit spreads, put credit spreads, call credit spreads, iron condors, iron butterflies. That's generally the highest ROI strategies because you're taking in a credit and you have a fixed amount of risk that's associated with that, a max loss. Those generally end up being the highest ROI per trade strategies. Now, this is different and this is going to be an interesting conversation, so let me know on Facebook or Twitter how you guys think about this and what your comments are on this too. But this is different that actually keeping money in your account.
The way that I look at it is there's highest return ROI strategies which in most cases, are defined risk strategies like credit spreads, iron condors, etcetera, but when you actually look at which strategies actually keep the most amount of money and ultimately lead to the highest total dollar profits, then those strategies end up being more of the undefined risk nature, meaning the straddles and the strangles. This is evident in our back-testing framework and our back-testing report that we publish which is called "the profit matrix." When we went through and back-tested millions of different option strategies over hundreds of different securities, millions of combinations, what we found is again, even though a strategy might have the best ROI on trade entry like an iron condor or an iron butterfly, that doesn't necessarily mean that it translates into the highest total dollar profit.
What we see with straddles and strangles is we see higher total dollar profits, but at the expense sometimes of slightly higher volatility in the account because you're trading things that are more undefined risk that don't have built-in protection like an iron butterfly or an iron condor. And then what happens is that you generally get a little bit more flexibility in your account, meaning a little bit more of the ebbs and flows that come along with that, ultimately though, leading to generally higher returns and higher payouts on a total dollar basis. I think that's what you have to decide, is like which type of trader are you and are you willing to accept maybe some more ups or downs in your account over the long haul for higher returns or do you want more stability in your account that might end up being lower total dollar returns, but a good return on the money that you have invested and the capital that you put up in margin or risk exposure.
Hopefully this helps out. As always, you guys can take a look at all the different things that we have and all the different strategies that work in different market environments using our trade optimizer software that we built at optionalpha.com/toolbox. It's a really, really useful tool just to see what strategy works best in the current market environment because it is very different. There's no one unicorn strategy that works best in all environment. If you're 10 days from expiration versus 30 versus 60, you might have to tweak your option strategy just a little bit. As always, hopefully this helps out. Until next time, happy trading!
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