When we sell a Strangle we hope that neither side is “tested”, meaning that the price of the underlying doesn’t move beyond the strike of our short Put or short Call. Some traders worry about this and are even more worried about a situation in which both sides get tested. How often does that happen? Does the theoretical probability of touch on both sides accurately predict the historical performance? What does this mean for our mechanical strategy of rolling the untested side fo a Strangle toward the new 30 Delta once one side has been tested?
The formula of the theoretical probability of touch (POT) on both sides using a skewed Strangle in the SPY was displayed. The calculation was explained. Our study was conducted in the SPY from 2005-2015. We sold a series of Strangles with the Put and Call having the same Delta and held these trades to expiration. We then compared these Strangles which had Deltas on each side of 45, 40, 35, 30, 25, 20 and 16. The 16 Delta Strangle is of course our classic 1 Standard Deviation Strangle.
A table of the results compared the expected, actual and differential percentage on a probability of touch (POT) on both sides for each of the Deltas in the study. The table showed a huge differential between actual and expected POT, especially when the Deltas got smaller (wider wings), meaning the original chance of POT at trade entry was low. Tom and Tony noted that since the odds of both sides being touched are so low, you have to stay mechanical and roll the untested side if one side is tested. So where does the POT on both wings start to drop to Zero? A final table showed the results for Strangles with Deltas lower than 16. The table showed that in 11 years of study the 5 and 2.5 Delta were never touched on both sides.
For more on Probability Of Touch (POT) see:
Market Measures from January 4th, 2016: “Probability of Touch After Touch”
Best Practices from February 22nd, 2016: “Best Practices Around “Probability Of Touch”
Market Measures from April 8th, 2016: “Probability of Touch | Realistic Expectations”
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways, the results of our “game changing research” on the true probabilities of a short Strangle being tested on both sides and why worrying about a Black Swan event is nonsense.
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