Option trading has been gaining immense popularity in the retail segment of the Indian derivatives market with its ability to offer leverage and potential for amplified returns. Options have become a powerful tool for traders of all experience levels. However, navigating the world of options can be complex, and it requires a deep understanding of different strategies and their nuances. 

One of the most famous strategies used by traders is the short strangle. In this blog, we will discuss everything that is crucial for creating a short strangle and, most importantly, focus on the three different methodologies used for strike selection, along with the backtested results of how these strategies have performed historically. 

What is a Short Strangle?

A short strangle involves selling both a call and a put option that is out of the money, of the same expiry and underlying asset. By selecting call and put options at certain distances from the spot price, you can construct a short strangle. This distance can be equidistant or different for the call and put options, but as long as both are of the same expiry, it is termed a short strangle.

What are the Building Conditions for Short Strangles

The building blocks of a short strangle strategy can be broadly categorized into entry and exit conditions.

Entry Conditions:

  – Strike Selection: Determining which strike prices to sell

  – Market Condition: Assessing the volatility level using volatility index(VIX)

  – Instrument Selection: Deciding whether to trade in monthly or weekly options and what to trade

Exit Conditions:

 – Holding Period: Whether to hold the position till expiry or square off early

 – Adjustment Criteria: Deciding on adjustments of the position if the trade goes against you before expiry

Exit conditions are crucial. You need to decide whether to hold till expiry or exit earlier based on your profit target or risk tolerance. Adjusting positions is subjective and varies based on individual risk appetite and understanding. However, we will separately cover this topic in the near future.

The Probability-Profitability Relationship

In a short strangle, your objective is to sell strikes where the chances of the spot price reaching them are low. This means selling far out-of-the-money(OTM) options. The trade-off is between the probability of profit and the quantum of profit, which is inversely related. The further you go from the spot price, the lower the premium, and hence, lower the profit but higher the probability of profit and vice versa. 

This is also why selecting the appropriate strike prices is necessary for creating a short strangle, which ultimately is nothing but risk management in practice.

What are the different strategies that can be used for creating short strangles?

Strategy 1: Adding Up ATM Strikes

One way to select strikes is by using the ATM (At The Money) strike price of the contracts which you want to place your trades in. 

To achieve this goal simply take the premiums of the ATM call and put options, add them up, and select strikes just outside this range.

For example, if Nifty closes at 22,200 with ATM call and put premiums summing to 500, you would sell the 22,700 call and 21,700 put to create your short strangle.

Strategy 2: Using Volatility Index(VIX)

Another method involves using VIX, or the volatility index. In this method, you are supposed to calculate the expected Volatility over the expiry period.

For explanation purposes let’s take the case of Nifty 50 contracts, with 15 days to expiry, and India VIX which is the annual volatility number for Nifty 50 contracts at 20.27% and spot at 22000. Since India VIX is an annualized number you will need to convert the annualized number to a shorter period using the square root formula.

Short-term Volatility = (Annualized India VIX%)  / √(Time to Expiry)

So for a 15 day period, the time to expiry will be taken as √24. (Since VIX is an annualized number and there are 12 months in a year and hence 24 half months i.e 15 Days). If we multiply the short term volatility with the spot price we will get the range of Volatility expected. In our example this range will come out to be 918 points of Nifty. 

SPOT PRICE = 22200

INDIA VIX = 20.27%

RANGE = 22200 * (20.27% / √24) = 22000 * 4.14% = 918

So accordingly you will sell a call option with a strike price of 22900 and on the put side you will sell an option with a strike price of 21100. If VIX-based calculations give a wider range, it implies a higher probability of profit but lower premiums.

Strategy 3: Delta-Based Selection 

Delta indicates how much the option price changes with a one-point move in the underlying. To increase the probability of profit, you can use lower Delta values and adjust the probability-profitability curve as per your personal preference. 

For our study, we selected 0.3 Delta as the benchmark. 

Backtesting the Strategies

We ran a backtest over the last 10 years for all three methodologies above for Nifty 50 contracts, focusing on monthly expiries. Excluding the COVID period, the VIX-based strategy showed a 75% success rate, the ATM straddle 71%, and the 0.3 Delta-based strategy 62%. 

VIX-based strategy had fewer margin shortfalls, making it suitable for risk-averse traders. Including the COVID period, the success rates remained similar, but the max loss increased, highlighting the impact of extreme Volatility.

Concluding Statement

The choice of strategy depends on individual risk tolerance and market conditions but as market participants, we need to make sure that things are in our favour statistically to gain an edge. Eventually this is what gets compounded in terms of incremental returns. VIX-based strategy offers higher probability but lower returns, while Delta-based strategy offers higher returns with higher risk. Understanding these nuances is key to successful options trading.