Choosing Strikes Based on IVR
Oct 26, 2018
Not too long ago, the Market Measures team published new research on how traders can consider adjusting trade duration based on market environment.
In short, a tastytrade study of historical data showed that in lower implied volatility environments, trade performance improved with longer trade duration - while in higher implied volatility environments, trade performance improved using shortened trade duration (considering both risk and reward).
Today, we’re are looking at a similar topic, but instead of trade duration, the focus is the "delta" of the trade (aka the strike of the option).
As we know, the delta of a given option will generally be higher when the strike price is closer to at-the-money, as opposed to out-of-the-money options, which have lower deltas.
On a new episode of Research Specials Live, the hosts wondered whether the delta of an option in a given trade might also be adjusted based on the volatility environment.
Imagine, for example, that Implied Volatility Rank (IVR) is elevated in hypothetical symbol ABC, and you are considering selling premium. Based on historical data, do trades perform better when higher delta options are selected, or when lower delta options are selected?
Feeling this a worthwhile line of thinking, the research team designed and executed a study that was intended to help shed light on this question.
As such, they set the following parameters for the study, and then backtested the data:
Utilized historical data in SPY (2005-2017)
Compared selling 16, 20, and 30 delta strangles when:
IVR > 50%
IVR < 50%
Recorded average P/L, win rate
As you can see in summarized data below, the average P/L rose sharply for instances in which IVR was elevated along with the "delta" of the trade.
The second slide below shows how dramatically the P/L jumped when increasing the delta of the option in the trade - particularly when IVR was elevated.
While we haven't included in this post the results of the backtest in which IVR was below 50%, but those findings also showed increased P/L when the delta of the option was increased. However, the change was far less significant.
We hope you'll take the time to review the complete episode of Research Specials Live for a full breakdown of the results when your schedule allows.
As it stands, this research certainly provides "food for thought" regarding strike selection when implied volatility is rising. If your interest is piqued, but you need further convincing, you could always mock trade (i.e. paper trade) this approach and observe how the trades behave and their associated P/L.
Mock trading is a great way of gaining experience with new/unfamiliar positions because it eliminates the potential for trading losses.
If you have any questions about this material, we hope you’ll leave a message in the space below, or send us a tweet to @tastytrade or an email to firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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