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Easy trading strategy: Do stops work?

IWM Option Chain
IWM Option Chain

In our quest to understand trading options for income, the topic of this article compares using stops vs. no stops when using a strangle option strategy.

What is a Strangle? (see picture above: IWM Option Chain)
A Strangle is an option strategy in which both a Call option and a Put option are sold concurrently. The strikes selected for both options (Call and Put) are OTM (out of the money), which means the current price of the underlying asset (IWM) is below the strike price of the Call, and above the strike price of the Put.

For example, with IWM at $115.93 and selecting the option chain FEB 14 which is nearest 45 DTE (days till expiration), we've selected to sell the Call 122 strike and the Put 110 strike for a premium of $80 (100 x $0.80) per Strangle. This is based on an IV (implied volatility) for the chain of 17.17%, and strikes selected at a risk level of 1 SD (standard deviation). At this level of risk, the POP (probability of profit) is approximately 68%.

The margin requirement is $1,806. Note: if IV increases significantly, the margin requirement will also increase, which could result in a margin call (and the automatic closing of the position by your broker with a big loss). This is the issue associated with undefined risk strategies like the Strangle; an alternative is to use an Iron Condor which is a defined risk strategy.

For a clear idea of the risk of a Strangle, look at the Risk Profile (see picture above: IWM Risk Profile). From the picture you can see that there is no limit to the loss if the underlying asset move strongly beyond the selected strikes (up or down).

Do stops work?
To test this, we review the work performed by Tasty Trade on three separate assets: IWM (the Russell 2000 ETF), GLD (the Gold ETF), and FXE (the Euro Currency Trust ETF).

Tasty Trade used the following criteria: selling a Strangle at 1 SD when the IV Percentile exceeded 50% in the option chain nearest 45 DTE. This test was conducted over a 5-year period.

When a trade is initiated, the position was managed in two ways: without stops, exiting the position when the premium reaches 25%, 50%, 75%, and at expiration (for full premium, or a loss); and with stops, exiting if the premium or loss reaches the above percentages, and at expiration.

The results? (see pictures above for IWM, GLD, FXE). For all three assets, the use of stops resulted in losses or smaller profits at the 3-percentile levels. Since assets exhibit random price movements, it is expected that some percentage of these movements will be large enough to cause one side (or the other) to be challenged resulting in a temporary loss. Also, given the high IV Percentile requirement for entering the trade, the longer the position is held (to the 75% level), the more likely IV will drop (which helps Strangles); this is why the P&L improved at that level vs. 25% and 50%.

In conclusion, when entering trades with high IV Percentile, the probability of the trade being profitable is also high. However, IV Percentile could continue to increase before it starts to collapse, which would lead to stops being tested. If you are concerned about the unlimited risk associated with the Strangle, consider using an Iron Condor (with limited risk) with wide dollar spreads on each leg (or credit spread).

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

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