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Trading options for income: The Kelly criterion vs. IV rank

The Kelly criterion vs. IV rank
The Kelly criterion vs. IV rank

In our quest to understand trading options for income, we often consider ways to improve our entry criteria. In the past we've looked at IV Rank greater than 50. Now we compare the Kelly criteria to IV Rank for the SPX using Iron Condors (ICs).

A short Iron Condor is a defined risk option strategy composed of the following: an OTM (out of the money) Put credit spread and an OTM Call credit spread, both within the same option chain. A credit spread is a vertical option strategy composed of a short OTM option plus a long further OTM option. The capital at risk is the difference between the short and long strikes less the premium received.

The Kelly criterion is based on the following formula...

( (POP x (b + 1)) - 1 ) / b where POP = probability of profit; b = (max profit / max loss)

The purpose of the Kelly criterion is to minimize your exposure to high risk scenarios (by reducing trade size) while encouraging trading more aggressively in high probability scenarios. For example, given a 50% POP (probability of profit) with a 5:1 payout (or b= 5), the max suggested percent capital to risk is 40%. However, if the POP increased to 85% while the payout dropped to 3:7 (or b= 0.43), the max percent capital at risk suggested by the Kelly criterion rises to 50%. NOTE: at a POP of 85%, if the payout (or b) was to drop below 0.176, this would result in a negative percent from Kelly; we could then use, as an entry signal, any positive result and reject those that are negative. The formula would be POP = 1 / (b + 1).

This is exactly what Tasty Trade did recently when it compared entry signals (Kelly vs. IV Rank > 50) for the SPX over a 5 year period. The test criteria were as follows: start with a $100 thousand portfolio; if an entry signal was received on the first trading day of each month, an IC (with $5 wide spreads) was placed at 1 SD (standard deviation) which would set the POP at 68%; the capital employed for a Kelly signal was the recommended percent based on the premium received (but not to exceed 5%) of the current account size; the capital employed for an IV Rank greater than 50 signal would be 3% of the account size; and the position was to be held to expiration (45 days).

The results: the P&L of the Kelly signal was more than twice the IV Rank P&L ($8,280 vs. $4,074); the Kelly percent winners was less than IV Rank (68% vs. 75%); Kelly had more trades (19 vs. 8); and Kelly had the biggest loss (-$6,050 vs. -$3,186).

In conclusion, the Kelly criterion offers a good alternative to the IV Rank greater than 50. While risk increased (68% vs. 75%), the P&L significantly improved (more than double). The biggest loss for Kelly was nearly double that of IV Rank, and this is due to the higher number of average contracts per trade (13 vs. 9).

The Kelly criterion has its place in recommending the max capital at risk for a selected POP and premium received. This makes it a valuable position sizing tool (which we use at Options Annex).

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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