A defined risk trade has a known risk at order entry. While an undefined risk strategy such as naked calls may theoretically have infinite risk we wanted to know how often an undefined risk trade would challenge the margin parameters set by brokerage firms. This type of move is generally defined as two standard deviations.
The Options Jive from February 9th, 2016, “Do Naked Options Really Have Undefined Risk?” has more information on this topic.
Since brokerage firms generally place the margin on undefined risk trades at a two standard deviation move, how often do these moves actually occur? The first study was conducted using SPY, TLT, GLD and FXE with data from 2010 - 2015. We sold the 1 SD Strangle every 5 business days and used the options closest to 45 days to expiration (DTE). We found the number of times a short strangle traded at a loss equivalent to the amount of margin required to initially place the position. The second study was conducted using the same parameters but in four big name stocks: AAPL, AMZN, GS and IBM, which usually experience higher implied volatility (IV) than the ETFs.
A table of the results (300 per ETF) of the four ETFs was displayed. The table included the number of losses that were larger than the initial margin requirements. A second table for the individual stocks (300 per stock) was also displayed. The table included the number of losses that were larger than the initial margin requirements.
An important note of caution is that while losses that are greater than the margin requirement are rare, when they do happen, they are typically much larger than the initial margin requirements. An underlying could move 5 standard deviations or more. This is why it's important to keep position size in check relative to your account. The tastylive philosophy is to trade small and to trade often and that’s the main reason why.
Watch this segment of “Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and to see how often naked positions reach a loss of two standard deviations or more to better understand your risk.
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