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Consistent income trading options: Does buying premium when IV is low work?

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In our quest to understand trading options for income, we often consider strategies for low IV (implied volatility) environments that occur during bull markets. One strategy for consideration is the long Strangle, a debit strategy in which we pay for the position.

The debit Strangle (the opposite of a credit Strangle) is defined as concurrently buying two options (a Put and a Call) that are OTM (out of the money), or further away from the current price of the underlying asset. Both options are in the same option chain.

The characteristics of a Strangle are: Theta is negative, which means that time decay hurts this position; and Vega is positive, which means any increase in volatility benefits this position. Unlike the short Strangle, there is no limit to the max profit that can be obtained.

In low IV environments, we are expecting IV to expand to normal levels as we rely on reversion to the mean. To determine if this expectation is valid, Tasty Trade performed a test on the following ETFs: GLD, QQQ, and USO over a 2-year period. The test criteria was: purchase a 1 SD (standard deviation) Strangle on the 1st of the month if IV Rank is below 50 percent; and manage the position when 25, 50, 75 percent of the profit is realized, and hold to expiration.

The results: in all cases (except GLD at 50 percent earned $8.00) the P&L was negative and the percent winners was below 53 percent. And, except for GLD, holding till expiration resulted in the lowest loss, indicating that low IV Rank does not necessarily revert quickly; nor does it result sufficient price movement for a profit.

In conclusion, the long Strangle strategy for low IV environments (when IV Rank is below 50 percent) does not work. The key problem is that if the underlying asset continues to move up (the reason for low IV Rank), volatility continues to drop (which is a detriment). In addition, the position has to contend with an ever increasing daily loss due to time decay (Theta). If we decide to locate our strikes closer to ATM (for example, at 0.5 SD), the cost goes up dramatically will increasing the POP (probability of profit). Another approach might be a long Condor (using two debit spreads), which would reduce the impact of cost, Theta, and Vega.

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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