Buyside Strategies EQD Research Volatility
Oct 1, 2020
By Russell Rhoads, head of research
A trader recently reached out asking about an option trading approach that they picked up from a book written back in the 1990’s. The basic idea was to buy a long-dated strangle and consistently sell shorter-dated strangles with a narrower range than the long strangle. After mulling it over for a few days, I decided to have a look at how buying a three-month NDX strangle combined with selling a one-week NDX strangle would work out.
The first run at this involved using data from June standard expiration through September standard expiration. In 2020, this means starting on June 19 buying an NDX strangle that expired on September 18. The first short strangle involved selling an option that expired the following Friday, June 26. The process is repeated each Friday as one short strangle expires and another one-week short strangle is initiated. The other piece of the strategy involved choosing the option strike prices for both the long and all the short strangles. In order to choose strikes, I turned to the Nasdaq-100 Volatility Index (VOLQ). VOLQ offers a consistent 30-day measure of NDX implied volatility based on NDX option pricing. Implied volatility can be converted to predicted moves for the underlying market using the formula below:
If VOLQ is going to be used in place of implied volatility then the formula would be slightly adjusted and look like this:
On June 19 there were 63 trading days until standard option expiration on September 18. VOLQ closed at 27.61 and NDX closed at 10008.64. The following process was used to choose the long Sept. 18 options for this long/short strangle approach.
Step 1 – Convert VOLQ to a 63-trading-day projection
Step 2 – Calculated up and down 13.81% from the NDX closing price of 10008.64
Step 3 – Find the strikes closest to the calculated levels in Step 2
11400 is closest to 11390.83
8600 is closest to 8626.45
Based on these calculations, the long strangle part of this strategy results in the following trades –
Buy 1 NDX Sep 18 8600 Put @ 234.00
Buy 1 NDX Sep 18 11400 Call @ 60.00
The same process was repeated using NDX at 10008.64 and VOLQ closing at 27.61 to choose the strikes for the short one-week NDX strangle.
Step 1 – Convert VOLQ to a five-day projection
Step 2 – Calculated up and down 3.89% from the NDX closing price of 10008.64
10400 is closest to 10397.97
9625 is closest to 9616.30
Based on these calculations, the short strangle part of this strategy results in the following trades –
Sell 1 NDX Jun 26 9625 Put @ 66.00
Buy 1 NDX Jun 26 10400 Call @ 14.00
The initial result is a combined position that is long the NDX September 18 8600/11400 strangle and short the NDX June 26 9625/10400 strangle for a net cost of 214.00 points. The short strangle process was repeated twelve more times leading up to standard September option expiration. The results of all these transactions shows up in the table below.
A few notes about the table. First, the short option trades are placed on the line corresponding to their expiration, the trades executed on June 19 show up on the June 26 line in order to make tracking performance easy to follow. This approach does suffer a bit early on as the short strangles ended up in the money for both the first two weeks in July. However, those were the only two losing short strangle trades over this time period. On August 28, the short call also finished slightly in the money, but not enough to turn the trade into a loss.
August 28 is a date to focus in on as the long strangle was up 420.00 points. My approach is 100% systematic, but a sane trader would probably book that big profit and move on to buying a longer-dated strangle in place of the one with such a big profit.
After witnessing the success of this approach during the high volatility period in 2020 I decided to run another quick test during a low volatility period. Specifically, I wanted to see what would happen during a time period where neither of the long options in the longer-dated long strangle were in the money over the three-month period. This actually was the case between June and September standard expirations in 2019.
Standard option expiration in June 2019 occurred on June 21 and the NDX closed at 7728.78 with VOLQ finishing the day at 17.88. The trades below are based on these figures and again 63 trading days until September standard option expiration.
Buy 1 Sep 20 7025 Put @ 89.00
Buy 1 Sep 20 8425 Call @ 35.00
As in the 2020 example a total of thirteen one-week short strangles were sold over this 3-month period. The results for this time period show up below. A couple of notes with respect to the short strangles, if there is a holiday the VOLQ conversion is based on four days instead of five days. Also, the third Friday NDX options are AM settled, versus all the non-third Friday options which are PM settled. Five days is still used as the day count due to overnight risk associated with AM settled options.
At no point during this 2019 time period did the NDX violate either long strike price. In fact, there is only a single week where it increased in value (August 2). This was also a pretty bad week for the short strangle trade which racked up a loss of 135 points. That bad week resulted in the combined trade falling to showing an unrealized loss. In the long run the cumulative profit for selling strangles came in at 267.00 points, which more than made up for the loss of 124.00 points for the long strangle.
This is just the beginning of researching combining long long-dated and short short-dated strangles with the strikes being dictated by VOLQ. However, at first glance this approach appears to be promising. As always, any new findings will be shared in this space.