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Consistent income trading options: Low implied volatility strangles

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In our quest to understand trading options for income, we often consider using strangles when the underlying has low IV (implied volatility). From prior articles, we understand that the higher the IV Rank (over 50 percent), the greater the probability of success; this simply reflects that IV tends to be mean reverting (i.e., it tends to quickly return to its average when overextended).

IV Rank is defined as follows: (Current IV - 52 Week Min IV) / (52 Week Max IV - 52 Week Min IV); and it is expressed as a percentage.

If high IV Rank leads to improved outcomes, why not simply trade underlyings that currently have high ranking?

Well, there are two problems: First, simply limiting your trades to only underlyings that currently have high IV Ranking would drastically reduce the number of annual trades available. And second, many underlyings with high IV Ranking typically have illiquid option chains, making them unsuitable for option trading.

A better approach would be to trade known underlyings with liquid option chains regardless of IV Rank, and simply adjust size (capital at risk) and/or POP (probability of profit) accordingly. That is, you can increase size or reduce POP (to bring in more premium) for high IV Rank periods, and vice versa for low IV Rank periods.

Tasty Trade has performed numerous tests using the Probability Model, and their results indicate that actual price distributions of underlyings (especially ETFs) tend to fall within a normal distribution more often than the model expresses. For example, at 1 SD (standard deviation) the POP of a strangle would be 68% (per the model); whereas, actual results indicate a slightly higher POP (of around 70 percent or better).

To determine if selling strangles in low IV Ranking underlyings is a viable strategy, Tasty Trade conducted a test over 5-years using the following ETFs with liquid options: SPY, GLD, EWW, TLT, and IWM.

The test was conducted as follows: enter a 1 SD strangle at the beginning of each month using option chains with 45 DTE (days till expiration) and IV Ranking under 50 percent. Determine if the IV Rank falls between 0 - 24 percent, or 25 - 49 percent. Manage the position in two ways: exit when 50 percent profit is achieved, or hold till expiration.

The results: across 5-years and 5 ETFs, there were 232 trades. This is around 9-10 trades annually for each ETF; or around 2-3 trades annually per ETF where the IV Rank exceeded 50 percent. The total P&L was: $2,919 @ 50% with 89% winners; $5,028 when held to expiration with 80% winners. Note: at 1 SD we would expect the percent winners at expiration to be around 68 percent; not 80%.

It is interesting to note that when viewing the trades by grouping (0-24 percent and 25-49 percent), the former had a negative P&L, the largest loss (-$2,655), and accounted for 135 out of 232 trades (or approximately 58 percent). This would indicate that changing the risk level from 1 SD to 1.5 or 2 SD would likely result in a positive P&L (considering the negative P&L is small). Since there is no breakout by risk level, or breakout by short Put and short Call, further research would be required to optimize the strangle strategy for IV Ranking below 25 percent.

In conclusion, this test indicates that low IV Ranking trades with liquid options is viable; however, there is more research needed to optimize this approach.

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