Delta Risk and Reward
Jun 23, 2016
Collecting premium by selling strangles is one of our favorite strategies at tastytrade. The deltas of the options we sell determine our risk. Therefore, the delta width between our two short strikes is a key consideration.
tastytraders already know that an option’s delta tells us the approximate probability of being in the money at expiration. A 50 delta option (which is an at-the-money option) has a 50% chance of being in the money. Higher delta options have a greater probability of being in the money. Because there is greater risk, higher delta options collect more premium than a low delta option.
To determine which delta options offer the greatest risk/reward, we conducted a study comparing short strangles in SPY with deltas ranging between 5 and 45 with 45 days until expiration.
Higher deltas increases our P/L. Higher deltas also decreases the probability of the option being out-of-the-money. For example, selling a 45 delta strangle allowed us to collect $88 in premium versus just $22 for a 5 delta strangle. However, the 45 delta strangle has a 10% probability of being out-of-the-money at expiration compared with a 90% probability of the 5 delta strangle being out-of-the-money. Selling a smaller delta strangle collects significantly less premium but also stands a better chance of remaining out-of-the-money.
In our study, we found the optimal strangle rests somewhere between 10 and 20 deltas. This is the level at which our average P/L rises and our win ratio increases with greatest velocity. This is the sweet spot between premium collected and win ratio.
For aggressive traders, selling higher delta strangles is attractive because of the premium collected. More conservative traders may want to err on the side of higher win rates by selling smaller deltas. tastytraders want to maximize premium collected without sacrificing win rates. We don’t go for broke, nor do we fear risk. We simply want to find that spot where premium collected justifies the risk taken.
Call it the “tasty spot,” if you will.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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