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Consistent income trading options: Adjusting strangle based on IV Rank

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In our quest to understand trading options for income, we often consider adjusting the POP (probability of profit) based on the IV Rank of the underlying. That is, during high IV Rank we should get more aggressive with a POP of 68 percent, which is 1 SD (standard deviation) for a short Strangle; and with low IV Rank we should become more cautious with a POP of 95 percent, which is 2 SD.

A short Strangle is an option strategy in which two options are sold with strikes that are OTM (out of the money). For example, if the underlying asset has a current price of $500, then a short Strangle could be the following combination: short Put 485; short Call 515.

Tasty Trade recently conducted a study to determine if a blended Strangle would significantly outperform a standard Strangle. The test was conducted with the SPX over a 5-year period, and at 3-levels of risk: 1 SD, 1.5 SD, and 2 SD. Four positions (including the blended Strangle) were entered at the beginning of the month and held through expiration.

The criteria for the blended Strangle is: if IV Rank was at or below 24, then enter a 2 SD Strangle (the expectation being that IV will increase due to greater price fluctuation); if IV Rank is between 25 & 49, then enter a 1.5 SD Strangle; for IV Rank at 50 or greater, enter a 1 SD Strangle (the expectation being that IV will decline as price will likely consolidate after large moves).

As per the chart, there were 39 occurrences where IV Rank was at or below 24; 14 occurrences for IV Rank between 25-49; and only 7 occurrences where IV Rank was at or above 50.

The results: The highest risk level (or lowest POP) at 1 SD had the highest P&L at $38,208 but at the expense of the largest drawdown (-$9,215) and lowest percent of winners (78%); looking at the graph, we can see how erratic the P&L curve is at 1 SD. As we moved to 1.5 SD we can see that the P&L drops to $22,942, but the P&L curve becomes less erratic with the largest drawdown dropping dramatically ($3,477) and percent winners rising considerably (92%). At 2 SD the P&L drops to $11,130, but the P&L curve has no drawdown since the percent winners are at its max (100%).

How did the blended Strangle do? Somewhat similar to the 1.5 SD level, with a P&L of $21,924, a max drawdown of -$4,560 and a percent winners of 98%. Looking at the equity curve, we can see that the big drawdown occurred in the first quarter of 2009 during a bear market. Apparently the 1 SD positions during high IV Rank resulted in large losses which took over two years to overcome before the equity curve reached the same profit level as the 1.5 SD curve. In fact, the largest growth in the blended Strangle occurred because IV Rank shot up during July 2011 and then consolidated for the next two months. This gave the more aggressive 1 SD position a huge boost in revenue; a situation that has not occurred since.

In conclusion, the blended Strangle did not provide exceptional performance, calling into question the strategy of getting aggressive (at 1 SD) when IV Rank is above 50 percent; it is far simpler to set your POP at 90 percent (1.5 SD) and avoid the large potential drawdown of the blended approach. From our own testing at OptionsAnnex.com, we have found that separating the Call and Put SDs, and setting SDs based on current market conditions (bull vs. bear markets), provides a much better outcome with smooth P&L curves. At the very minimum, if you want to avoid any drawdown while sacrificing P&L, the 2 SD approach for any condition will work.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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