In our quest to understand trading options for income, we often have a short-term bullish assumption after IV (implied volatility) exceeds 50%. The typical approach is to sell a Put (or Put credit spread) in anticipation of the market moving up (and IV dropping). But does it also make sense to include selling a Call (or Call credit spread) further OTM?
Tasty Trade conducted a test recently to determine if profits would improve by including income from a short Call. The following ETFs (exchange traded funds) were used: DIA, EWW, FXY, and IWM.
Trades were placed when IV Rank exceeded 50%. It was not mentioned the time-frame of the data (presumably over 5-years), or the DTE (days till expiration) of the options (presumably close to 45-days).
The strategies used were...
· Sold Put at 0.5 SD (standard deviation) (POP 69%)
· Sold Put at 1 SD (POP 84%)
· Sold Strangle (Put @ 0.5 SD; Call @ 1 SD)
· Sold Strangle (both Put and Call @ 1 SD)
The results (see Table above): in all four ETFs, the more aggressive Strangle (Put @ 0.5 SD; Call @ 1 SD) returned the highest P&L.
This is not surprising since the more aggressive strangle is taking on additional risk; in fact, it is the highest risk strategy. Typically we expect to get rewarded more as more risk is assumed.
Now the number of trades is small: DIA was 12 trades; EWW was 15 trades; FXY was 19 trades; and IWM was 11 trades. This is a total of 57 trades which is a small sampling statistically.
By comparing the results of all the strategies, we can determine if the higher risk Strangle resulted in additional losses, and we've presented this in the Table. This provides us with some measure of the potential volatility of our equity curve if we employed this strategy over many more trades.
First, all but one ETF had a Put loss at 1 SD or lower. The exception is IWM (the Russell 2000 index) which had two Put losses at 0.5 SD, and zero Put losses at 1 SD.
Second, all but one ETF had a Call loss at 1 SD. The exception was EWW (Mexico) with zero Call losses.
And third, the additional income generated by the short Call at 1 SD turned one of the 0.5 SD Put losses into a winner with a net increase of $800 ($1,803 - $1,003).
In conclusion, the aggressive Put @ 0.5 SD, while adding more premium, did so at greater risk adding one to two losses. The addition of a Call @ 1 SD added one loss (except for EWW with zero losses). By going further OTM (1.5 SD), the losses would likely drop on both sides increasing the Win ratio and providing the opportunity to increase the number of positions. What we don't know from this test is how much high IV ranking played a role in improving the P&L.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.