I came up with a question regarding short strangle in Quora which is how risky is it to sell an option strangle with a 16% delta on both the sides?

Short Strangle –

It is another good options strategy. Option value get decayed with time. This strategy takes advantage of it by buying both Call and Put Options. As there is time decay, considering the market price doesn’t move, the option price automatically decrease. So it has probability of profit of more than 50% by birth.

Considering you are talking about one standard deviation short strangle then mathematically probability of profit is approx. 74% to achieve breakeven points.

Two factors –

  • If you use this short strangle strategy in Indices like NIFTY or metals like GOLD where the impact of binary events and earning announcements centring a particular company makes less noise, your profitability of profit will increase more!
  • There is a recent study from two trading groups supporting the fact choose stocks which has high IV (Implied Volatility) increases profitability of profit to a certain degree.

If the above stuff looked like jargon to you, then keep reading –

Standard Deviation

Standard deviation measures certain outcomes relative to the average outcome. Here are how probabilities associated with certain multiples of standard deviations:

One standard deviation encompasses approximately 68.2% of outcomes in a distribution of occurrences.

Two does it for 95.4% and Three does 99.7%

For example, if a ₹100 stock is trading with a 20% IV (implied volatility), the standard deviation ranges are:

– One standard deviation – ₹80 to ₹120
– Two standard deviations – ₹60 to ₹140
– Three standard deviations – ₹40 to ₹160

So what is the chances of that ₹100 stock staying between ₹80 and ₹120? 68.2%
So what is the chances of that ₹100 stock staying between ₹60 and ₹140? 95.4%

and so on …

ITM = In the Market; OTM = Out of the Money

So, what? What does it have to do with options trading? Well, that is a long story, just remember –

Strikes with a probability of 16% ITM / 84% OTM capture a 1 standard deviation range for an OTM option

Jargon

What he is talking about in the question? First, let’s learn the jargon if you’re a newbie. Delta is the ratio comparing between option’s price and current trading price of the underlying asset/stock.

Theta is the Time decay ratio which is correlated with the change in an option’s price to decrements in time to expiration.

Trade Setup

To do make the delta 16% for the short strangle we will sell the 84% OTM call and 84% OTM put which means

There is a 16% chance of the correlated stock price moving higher than the call strike
There is a 16% chance of the correlated stock price moving lower than the put strike.

This equates to a 32% chance of the trade being in-the-money (ITM) at expiry of the options and a 68% chance of the stock price expiring within our strikes which is one standard deviation away from the stock price at trade entry.

If we want to have an even higher Probability of Profit, we can broaden our range on strikes on a strangle which is inversely proportional to the ‘return on the capital.