We believe there is an edge in selling option premium because Implied Volatility (IV) often overstates realized volatility. That means that the actual percentage that an out-of-the-money (OTM) option expires within the expected move is larger than what the theoretical model suggests. How does that translate into profits? On average, what type of returns should we expect and how ‘overpriced’ are various option strategies?
Our Study was conducted in the SPY (S&P 500 ETF)s from 2005 to the present. Using options with 45 days to expiration (DTE) we sold the 1 Standard Deviation Strangle and managed at 50% of max profit, taken as a loss at 2 times the credit received or held to expiration. We did the same with the at-the-money (ATM) short Put and the ATM Put Vertical Spread which had a 50 Delta for the short Put and a 35 Delta for the long Put. We also sold the ATM Straddle which was managed at 25% of max profit, taken as a loss even to the credit received or held to expiration. The purpose of the study was to obtain a yield of a percent of credit that a trader can expect to profit over time. This will help in building reasonable expectations.
A results table displayed results for all four strategies. Listed were an average P/L as a percentage of credit, the current price, expected average profit and average number of days in the trade. The expected profit is an estimate of average profit per trade over time using current prices. The 1 SD Stangle had the highest average P/L as a percentage of Credit at 25%, the Straddle 13%, the ATM Put 15% and the ATM Put Spread 5.2%. To put this to use an example was shown of an an account with $50,000 of capital reserved for 4 SPY Straddles. The calculation for determining the annual profit was displayed that figure was divided by the $50,000 to determine an annual return on capital (ROC). The result is an annual return that is reasonable to expect over the long run. Although a strategy like shorting Straddles can provide a nice profit and has a high probability of profit (POP), each strategy has a different risk profile and the performance may vary going forward. Profit expectations shouldn't be used to size and select positions. They can help evaluate current positions to build an expectation of how much you may make over time.
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for valuable takeaways and the results of our study and the calculations needed to determine a reasonable expectation for the future return on capital of various strategies.
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