Choosing the right strikes to buy or sell in any options trade is a critical component in the trade evaluation process.
The razor's edge that often differentiates a profitable trade versus an unprofitable trade is heavily influenced by strike selection.
On a recent episode of Best Practices, hosts Tom Sosnoff and Tony Battista discuss strike selection as it relates to short premium trading and some important factors to keep in mind when designing a winning portfolio.
The ultimate profit of any options trade is dependent on the value of the stock from trade deployment through trade closing (or trade expiration). Therefore, an estimate of where the stock price might be headed is an important consideration when establishing trade structure.
A stock's underlying price is influenced by its own business, the industry, and/or broader market sentiment. Despite this wide range of factors, traders do have at their disposal some important information that can help form expectations for a stock's future price.
Standard deviation is one such tool.
A stock's standard deviation is based on probability theory - relative to stocks, this is best described as a measurement of the distribution of occurrences around an average.
Basically, quantitative models can look back in history and categorize how frequently and how far stock prices settle from their starting price.
That figure, known as standard deviation, consequently represents the distance from a stock's price and the percentage chance of getting there over time.
There are three categories that capture the broad range of occurrences when talking standard deviation: 68.2%, 95.4%, and 99.7%.
The above means that a stock price will settle within one standard deviation from the mean 68.2% of the time, it will settle within two standard deviations from the mean 95.4% of the time, and it will settle within three standard deviations from the mean 99.7% of the time.
The slide below illustrates the expected settlement price of a stock and likelihood based on one, two and three standard deviation moves:
In practical terms, an option's implied volatility provides a trader with a useful estimate of a stock's range and can be used in conjunction with standard deviation.
If hypothetical stock XYZ is trading at a value of $100 in the market, then an implied volatility of 20% would suggest the +/-1 standard deviation of the stock (68.2% of occurrences) is within $20 of the current price.
That would mean we would expect the stock to settle at a value of between $80 and $120 on 68.2% of occasions over a given period of time. It would would also mean 95.4% of occurrences would see the stock settle between the +/-2 standard deviation range of $60 and $140, and 99.7% of occurrences would equate to a stock price between $40 and $160.
The above indicates that lower historical volatility in a stock will generally affect future expectations for a stock (future volatility) and the price of volatility in the market (implied volatility).
Folding all of this information back into the question of strike selection is where things really get interesting.
If we want to sell premium, and therefore sell strikes that have little chance of finishing in-the-money, tastytrade research has shown that selling strikes outside of one standard deviation from the mean can provide an optimal level in the "risk" part of the trading equation.
However, there is also a "reward" component to consider, which means we need to collect an adequate amount of premium (i.e. maximum profit potential) to be enticed into doing the trade.
On this episode of Best Practices, Tom and Tony review why they prefer to sell 84% out-of-the-money strikes - which are one standard deviation away from the current stock price -- and the associated "risk-reward" potential of such positions.
The chart below highlights the approximate delta of the preferred options to target according to standard deviation:
As you can see from the above illustration, Tom and Tony generally prefer to choose strikes with deltas of 16 or less when selling premium.
Obviously, these are only guidelines, and the precise trade structure selection will vary by trader, risk appetite, and market conditions.
We encourage you to watch the entire episode of Best Practices to get the best possible feel for strike selection in short premium trades.
If you have any lingering questions or feedback, please don't hesitate to contact us at email@example.com
As always, we thank you for being a part of the tastytrade community!
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.