In our quest to understand trading options for income, we often wonder when the VIX is trading within a certain range what the probability will be that the underlying will close or touch outside the 1 SD (standard deviation) expected move for a short Strangle.
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).
Our expectation is that the underlying should close outside the range 32 percent of the time (the probability of expiring in the money), since the POP (probability of profit) for a short Strangle at 1 SD is 68 percent; and 64 percent for touching, which is twice the probability of expiring ITM (in the money).
To determine the impact of the VIX, Tasty Trade recently tested the SPY over a 5 year period presumably using the Monthly with approximately 45 DTE (days till expiration). The VIX was measured and placed into one of five levels: < 15; 15-20; 20-25; 25-30; > 30.
The results: regardless of the VIX value, the percent Closes outside 1 SD were all below 32 percent; the highest was 29 percent for a VIX value between 15-20. Likewise, the percent Touches outside 1 SD were all below 64 percent; the highest value was 54 percent for a VIX value below 15. When the VIX fell between 25-30, both the Closes and Touches were zero.
In conclusion, out of a population of 70 occurrences, the average percent Close outside 1 SD was 20 percent, and for Touch it was 36 percent; both well below the expected probabilities. For a VIX value under 15 percent, you are mostly likely to be touched, while at 15-20 percent, you are most likely to lose at expiration.
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