How Big Market Corrections Affect Short Options
How Big Market Corrections Affect Short Options
By:Kai Zeng
Does the magnitude of market corrections correlate with the severity of losses from selling options? Learn more.
Historically, selling options can generate high success rates, and a large number of positive trades. However, downside risk for individual short options positions can be significant.
To illustrate this, let's use the loss to credit ratio, which measures losses by dividing the loss by the credit received.
We conducted a historical analysis on the S&P 500 ETF (SPY) to assess the magnitude of losses during "worst-case" scenarios over the past two decades.
By tracking the 45 days to expiration (DTE) for one-standard-deviation (1SD = 16 delta) strangles, we found that most losses were less than the credit received. The majority of losing positions had a loss to credit ratio smaller than one. Rarely did this ratio exceed three, with the median ratio being just one. This indicates that half of these occurrences experienced a loss smaller than the premium received.
Loses during corrections
Our analysis shows significant losses occurred during market corrections in 2008, 2018, and 2020, with 2022 included as another major market correction year.
Despite 2008 having the largest market pullback, the most substantial losses were observed in 2020. Interestingly, the loss ratios in 2022 were similar to those in 2018, despite the fact that 2022 represented a higher magnitude correction.
Two key factors contribute to these findings:
Speed of the market: Substantial losses often occur due to rapid market declines, leaving traders with insufficient time to adjust their positions.
Market volatility: When positions are established during calm market conditions with low implied volatility (IV), sharp spikes in volatility can result in severe losses, as observed in 2020.
Key takeaways
The magnitude of a market correction doesn't necessarily correlate with the severity of losses associated with short options positions. This was illustrated through the aforementioned historical comparisons (2008 vs 2020 and 2018 vs. 2022).
Investors may want to exercise caution when the major market indices are trending toward all-time highs, because these conditions may not offer "rich" premiums for option sellers, due to compressed levels of implied volatility (IV).
Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1
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