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Trading options for income: Probability model and duration

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In our quest to understand trading options for income, we rely on the Probability Model to determine the 1 SD (standard deviation) expected move to located the position of our short strikes for a short Strangle (or Iron Condor). The question is: just how accurate is the Probability Model relative to duration?

Duration represents the DTE (days till expiration) of the position. And the expected move is determined by IV (implied volatility) and duration.

A short Strangle is an undefined risk option strategy in which an OTM (out of the money) Call option is sold while concurrently selling an OTM Put option, 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 Strangle requires just 2 options to be sold (1 option per leg).

To determine accuracy base on duration, Tasty Trade recently tested five underlyings (AMZN, YHOO, SPY, GOOG, PCLN) over a three year period. Two DTEs were tested: 45 days and 6 months. Two metrics were recorded: the percent the price of the underlying stayed within the 1 SD expected move; and, if breached, the multiplier by which the underlying price exceeded.

The results: the 45 day duration displayed a significant advantage in accuracy over the 6 month duration in all cases except the SPY (which showed only a 3 point advantage) and YHOO (which showed a 5 point advantage). When breached, the average multiplier for the 45 days was lower than the 6 month for three of the underlyings (AMZN, YHOO, PCLN), slightly lower for GOOG (1.59x vs. 1.56x), and moderately lower for SPY (1.45x vs. 1.1x).

In conclusion, the longer the duration, the less accurate the Probability Model. Options Annex ran a Skew test on the SPX and found that the Weekly duration was very accurate relative to the Monthly or longer. This is one reason why we suggest using the 7 DTE duration as opposed to Tasty Trade's 45 DTE.

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