Unlike the first two components of the strategy, which are very long-term in nature, the income/premium collection trades are short-term in nature. What we typically do is simultaneously sell both a call and a put, out-of-the-money, and collect the premiums from both. Known as a Short Strangle, these trades are set up to be market neutral so that initially the risks are equally balanced between the upside and the downside.
The idea is that we bracket the market, and if the market stays within this range over several weeks, we will be able to close out the trade and repeat the process 12-15 times a year.
Source: Swan Global Investments
We have rather modest goals for each trade, hoping to collect somewhere between 0.30% and 0.50% per trade. If we do this successfully, we hope to generate enough return to help offset some, or all, of the carrying cost of the hedge in a flat or slightly rising market.
The risk in this trade, however, is if the market moves too far in either direction and starts getting close to those strike prices. We are very cognizant of those risks, and this is where our active management comes into play.
The vast majority of our portfolio management team—the traders, the risk officers, the PMs themselves—are dedicated to working this trade and keeping this trade within acceptable risk boundaries. If the market does move too far up or down we will implement additional adjustment trades to help mitigate risk, keep the trade market neutral, and try to claw back any losses an individual trade might incur.