Structuring A Short Strangle Portfolio: Why IVR, Portfolio Sizing And Research Make Total Sense

Introduction

Why should we tend to look for high IV ranks rather than chasing absolute IV numbers and getting burned if the price of the underlying starts crashing or rallying or just because of a spike in volatility hurting your margin requirements? Sticking to sound portfolio sizing (how much margin do you need to set aside?) and maintaining a rigorous approach that makes mathematical sense (for instance selling short strangles with deltas of 1 combine a high win ratio and attractive risk/reward) will benefit your portfolio the most.

1) Implied volatility

Let's get right into it: implied volatility metrics; raw data about an underlying's IV, do they provide you with a substantial edge? Take a look at the following graph for Alibaba.

(Click on image to enlarge)

(Click on image to enlarge)

Changes in volatility have a major impact on short-term and long-term options. The stock market is unpredictable and so is implied volatility. Finding an equilibrium between controlling margin requirements and projecting a realistic monthly premium income is what makes option selling so fascinating.

You hopefully notice huge swings in implied volatility. The average IV YoY is 38%. In an ideal world, we want to sell premium when IV is higher than 38% and thus has an IV rank of at least 50%. Since we're selling strangles, why does that make total sense? First, the width of our strangles depends on the implied volatility and in order to put some context our that number and compare apples to apples, we should have a clear understanding about how expensive options are. Shorting strangles when the IVR is subdued will lead to less room on the put and call side. To put another way, your profit range is narrower compared to selling premium in high IVR environments. Also, the higher volatility, the higher the premium and the higher our positive theta will be. Additionally, higher-than-average IVR tend to decrease throughout the life cycle of the trade except for upcoming earnings report which induce elevated implied volatility. As Alibaba shows swings in implied volatility, we have less occurrences to benefit from.

If we sell premium in low IV environments, we're at risk of taking on too much uncertainty in our P/L because:

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