The June 28, 2016 segment of Options Jive, "Defining Undefined Risk" demonstrated how traders could make use of the same assumptions that the Exchanges and Clearing Firms use to set the margin for a position to define their undefined risk on a trade. The Buying Power Reduction (BPR) a trader will experience is based upon a 2 Standard Deviation (SD) move in the underlying. We know that means in theory the move should stay within 2 SD about 95% of the time but how does it play out in practice?
Our study was conducted in four highly liquid ETFs, SPY, TLT, GLD and FXE, using data from 2010-2015. We sold a 1 Standard Deviation Strangle that was closest to 45 days to expiration (DTE) every 5 business days. We noted the number of times a Strangle traded at a loss equivalent to the amount of BPR required at trade entry. A table of the results showed that the percentage of losses that were greater than BPR was zero for three of the ETFs and 0.3% for the lone exception (GLD).
We know that ETFs are generally less volatile and have fewer outlier moves than their components but we do like to trade individual stocks too. We ran the same study using AAPL, AMZN, GS and IBM. A second table revealed that while the Strangles on AAPL went outside of the initial BPR level 1% of the time and was at zero for the other three. Tom and Tony noted that the system works, the amount of BPR that they debit you makes sense as a risk metric.
For more information on Buying Power Reduction see:
Market Measures from March 20, 2016: "Buying Power Expansion In Extreme Markets"
Options Jive from May 4, 2016: "Moves Affect Our Buying Power"
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the important takeaways and to see how accurate BPR based on 2 Standard Deviation moves is for determining risk.
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