Our favorite strategy for selling option premium is a Strangle. We most commonly sell what refer to as a 1 Standard Deviation (SD) Strangle which is comprised of a Put and a Call with a Delta of 16. Adding 16 and 16 equals 32 and 100 minus 32 equals 68. On a normal distribution curve 1 Standard Deviation represents about 68% of all occurrences. So our Strangle should fall outside of the price at expiration 68% of the time and since we know that Implied Volatility (IV) in the options overstates the expected move that gives us an even larger number in which our Strangle should expire OTM. Why don’t we go further out-of-the-money (OTM) and sell the 2 SD Strangle which theoretically should expire OTM 95% of the time?
Our study was conducted in the SPX from 2005 to present. Using options closest to 45 days to expiration (DTE) we sold the 2 SD Strangles comprised of a Put and a Call with a 2.5 Delta. We also tested whether managing at 50% of max profit improved our results over holding to expiration. A table showed that the actual percentage number of Strangles that expired within their strikes was 98% (as compared to 95% expected), the probability of touching either side was 10% and the actual touch of either side was 2.06%. A table of the results showed managing was the clear winner.
The results are not surprising so why do we still choose the 1 SD Strangles? It’s because traders also need to consider their risk to reward ratio and pay attention to return on capital (ROC). An example of a “perfect setup” of selling a 2 SD Strangle on February 2, 2016, the recent market low, when IV and Implied Volatility Rank (IVR) was at a high level was displayed. The example showed that even with high IV and IVR and a credit 50% higher than the 11 year average, you had a very low ROC using this strategy. In a best-case scenario, the annual ROC was 8.8% holding the trade to expiration and when managing at 50% the annual ROC came down to 4.4%. "This was not worth the blowout risk." The ROC from the 1 SD Strangle is far superior.
For more on 1 Standard Deviation Strangles see:
Market Measures from August 18, 2015: "Context Around Selling Strangles"
Market Measures from January 4, 2016: "Probability of Touch After Touch"
Market Measures from April 8, 2016: "Probability Of Touch | Realistic Expectations"
Watch this segment of Market Measures with with Tom Sosnoff and Tony Battista for the important takeaways and the results of our study to find out why we prefer selling 1 SD Strangles compared to 2 SD Strangles.
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