In our quest to understand trading options for income, we often consider whether more complex option strategies can outperform simple strategies. In this article, we compare the simple short Strangle to the more complex short Double Ratio Spread to determine which performs better.
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).
A short Double Ratio Spread is a defined risk option strategy which combines two bear Ratio Spreads (Call and Put). A bear Call Ratio Spread occurs when an OTM Call option is sold while concurrently buying 2 or more further OTM Call options (typical ratios are 1:2, 2:3, etc.). A bear Put Ratio Spread occurs when an OTM Put option is sold while concurrently buying 2 or more further OTM Put options. Both the Call and Put ratio spreads are within the same option chain, with the short strikes equidistant from the underlying price. A one lot Double Ratio spread requires 6 options (3 options per leg).
Each leg of the Double Ratio Spread should yield a net credit. This will require making adjustments to the ratio and the width between the short and long strikes.
To determine which strategy yields the best outcome, Tasty Trade recently conducted a test, over a five year period, of the following ETFs: EWW, GDX, IWM, and TLT. The test criteria was as follows: two positions were initiated if, at the beginning of each month, the ETF had an IV (implied volatility) Rank over 50% using the Monthly with 45 DTE (days till expiration). The first position was a 1 SD (standard deviation) short Strangle with a POP (probability of profit) of approximately 68%; the second position was a short Double Ratio with each short strike 1 point closer to ATM (at the money) than the Strangle, resulting in a POP less than 68% (to generate an equivalent credit).
The results: in all but one case (EWW), the Double Ratio had a slightly better P&L, with mixed results on both the percent winners and average ROC (return on capital).
In conclusion, while the Double Ratio Spread had a slightly better P&L, the Strangle would be the strategy of choice, for several reasons. First, the transaction costs for the Ratio Spread is 3-times greater (6 options vs. 2, for a 1 lot), which would wipe out the P&L advantage. Second, the more complex Ratio Spread requires more work to properly setup for each leg to yield a credit. And third, the more complex Ratio Spread will be more difficult to fill (and adjust).
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.