As the market continues its historic run to all-time highs in 2016, one has to wonder where and when the next correction might appear on the calendar.
Certainly, the combination of all-time highs in the S&P 500 and relatively low levels in the VIX has to have some volatility traders wondering if a long premium opportunity may be currently developing in the market.
Asking themselves the same timely question, the Market Measures team recently conducted and presented research that speaks to the performance of long premium straddles and strangles during periods of low volatility.
The goal of these efforts was to help volatility traders better understand the success rate of such an approach in historical context.
The study the team put together to better understand this question included the following:
Used data from the S&P 500 ETF (SPY), 2005 to present
Backtested buying straddles (long 50 delta call and put)
Compared when IVR < 5 and IVR < 10
Compared when managing profit at 25% of debit paid, 50% of debit paid, 100% of debit paid, and holding through expiration
IVR, or Implied Volatility Rank, is a tastytrade metric that helps one better understand the value of implied volatility as compared to the previous 52 weeks of trading. For example, if XYZ has had an IV between 30 and 60 over the past year and IV is currently at 45, XYZ would have an IV rank of 50%.
By filtering for instances in which IVR was below 5 and 10 in the SPY, the tastytrade study therefore isolated instances in which SPY implied volatility was at extremely depressed levels.
Interestingly, the results of the study indicated that even with these forgiving considerations, and the incorporation of a variety of profit management approaches, the long premium straddles did not produce a high probability of success.
Shown below are the results of the IVR < 10 approach:
As you can see from the above information, none of the 4 approaches examined in the IVR < 10 study produced a success rate above 50%. Looking at both studies, none of the approaches produced a positive average profit, either.
While these results without question suggest a lower probability of profit than many of the short premium strategies outlined on the tastytrade network, it doesn’t mean there isn’t a place for such positions in your portfolio.
Depending on your unique portfolio and approach, there may be instances and market conditions that indicate long premium positions may be useful for risk mitigation. Additionally, some market participants deploy delta-neutral long premium positions (meaning the option position is hedged with stock) that are then scalped - which can potentially increase the returns of the positions.
Another method of managing portfolio risk is to lean short delta in conjunction with an overall net short premium portfolio - an approach that has been outlined on several occasions on the tastytrade network.
If you have any feedback or questions on the above topics we hope you’ll reach out at firstname.lastname@example.org.
Thanks for reading!
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.