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Trading options for income: High IV rank and price reversion

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In our quest to understand trading options for income, we recognize that IV Rank generally increases as the price of the underlying declines. When IV Rank exceeds 50 percent, would this be an opportune time to put on a bullish position? This article will test that theory using two bullish strategies: short Puts and short Put Ratio spreads.

A short Put is an undefined risk option strategy in which an OTM (out of the money) Put option is sold, resulting in premium received. The max gain is the premium; the max loss cannot be determined which is why this is called an undefined risk trade. A one lot short Put consists of 1 option.

A short Put Ratio is an undefined risk option strategy composed of the following: an OTM long Put and two further OTM short Puts, both within the same option chain. The max gain is the premium received; the max loss cannot be determined which is why this is called an undefined risk trade. A one lot short Put Ratio consists of 3 options (1 long, 2 short options).

To determine if high IV Rank is a reliable indicator for initiating a bullish strategy, Tasty Trade recently tested the following ETFs over an unspecified period of time (probably 5 years): IWM, FXY, DIA, and EWW.

The test criteria was as follows: all trades entered at the beginning of the month if the IV Rank exceeded 50 percent using a Monthly option chain with close to 45 DTE (days till expiration); all positions were held to expiration; a short Put and short Put Ratio position was entered with the short strikes at 69% OTM each (approximately 0.5 standard deviation), and at 84% OTM each (approximately 1 standard deviation), for a total of four positions.

The results: in all cases, the short Put had a higher P&L than the corresponding short Put Ratio spread (except for DIA at 84% which were nearly the same); in all cases, the P&L for the higher risk 69% OTM positions exceeded the 84% OTM positions; and in all cases, the 84% OTM positions either exceeded or matched the percent winners of the 69% OTM positions.

In conclusion, the simpler strategy of the short Put is preferred over the more complex strategy of the short Put Ratio spread, since the P&L was higher and the commissions lower. It is interesting to note that the more aggressive 69% OTM positions had matched the percent winners on two of the four ETFs (DIA and EWW) and was close on FXY; probably due to the average IV Rank being greater than 60%. What is missing from this test is the maximum drawdown of each position, which would more clearly reflect the risk.

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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