On today's episode, Katie's strangle in /CL has moved against her as the price of crude oil has sold off by about a $1.50. As with most leveraged products, large moves in the price of the underlying can have a significant impact on P/L. Therefore, it's time to play defense. While the duo is still bullish on oil, they need to be mechanical. First, they take a look at OVX, this is the volatility index of the crude oil ETF. Volatility is not as high as they'd like, but to stay mechanical, they roll down the untested side. As part of their /CL strangle strategy, they typically look to roll the untested side when the tested side has a delta of around 30 or greater. Currently, the tested side has delta value of about 25 and is trading for a price of $0.71. If it becomes a 30 delta option, it will trade for about $0.95. Tony estimates this through extrapolation…by looking at the price of the option that's currently at the 30 delta strike (the put option in this case, as it's the tested side). If the price of crude oil were to continue it's downward move, this would result in a significant loss on the overall position.
Taking a look at the untested side, the strike they initially sold has about a 95% probability of expiring OTM. As a result, they are essentially long crude oil here and need to make an adjustment to neutralize the trade. To defend the position, Tony and Katie roll the untested side (call side) down to the strike that has a delta value of around 12. They choose this strike as a way to defend the trade while not over-hedging the position and becoming vulnerable to a strong bounce in the price of the underlying.
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