Two of our favorite strategies for selling option premium are the Iron Condor and the Strangle. We use them to generate positive Theta (time decay) and to take advantage of an Implied Volatility (IV) that usually overstates the expected move. These two strategies are, generally speaking, directionally neutral. Where the strikes are placed can make the trade more risky and more directionally biased. The static approach to construct these trades is by choosing strikes at either a fixed dollar amount or a percentage away from the price of the underlying. A “dynamic approach” uses option probabilities, usually based on Delta to choose the strikes. What are the advantages in using probabilities this way in trading?
A bell curve graph of Implied Volatility versus the strikes was displayed. The graph showed the downside Skew that most equities have in which Puts are more expensive than Calls. We believe we can take advantage of the volatility skew by placing our Puts farther away and our Calls closer. Tom and Tony noted that “if you're going to be short premium you have be short Delta to have downside protection against a selloff. What if instead of being short Delta, you just made the adjustment on the option strikes you select at order entry?”
Static or fixed strikes could be too far or too close to the price of the underlying because they don’t take into account the probabilities. A graph showed that by using dynamic strike selection, the strikes will lie at the same points on the distribution curve. Fixed-width or static strikes will not accommodate for upside or downside skew. Tom pointed out that the ultimate point here is: “Will adjusting strikes be able to provide us with a cleaner alternative to carrying short Delta?”
For more on Dynamic Strike Selection see:
Market Measures from April 23rd, 2015: “Fixed vs Dynamic Width of the Spread”
tasty BITES from September 2nd, 2015: “Iron Condors | Fixed vs Dynamic”
Best Practices from March 22nd, 2016: “Choosing Wings Based on Probabilities”
Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the valuable takeaways and the results that show how Dynamic Strike selection using probabilities can balance out our risk-to-reward.
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