Delta Risk and Reward
Jun 23, 2016
Collecting premium by selling strangles is one of our favorite strategies at tastylive. The deltas of the options we sell determine our risk. Therefore, the delta width between our two short strikes is a key consideration.
tastylivers already know that an option’s delta tells us the approximate probability of being in the money at expiration. A 50 delta option (which is an at-the-money option) has a 50% chance of being in the money. Higher delta options have a greater probability of being in the money. Because there is greater risk, higher delta options collect more premium than a low delta option.
To determine which delta options offer the greatest risk/reward, we conducted a study comparing short strangles in SPY with deltas ranging between 5 and 45 with 45 days until expiration.
Higher deltas increases our P/L. Higher deltas also decreases the probability of the option being out-of-the-money. For example, selling a 45 delta strangle allowed us to collect $88 in premium versus just $22 for a 5 delta strangle. However, the 45 delta strangle has a 10% probability of being out-of-the-money at expiration compared with a 90% probability of the 5 delta strangle being out-of-the-money. Selling a smaller delta strangle collects significantly less premium but also stands a better chance of remaining out-of-the-money.
In our study, we found the optimal strangle rests somewhere between 10 and 20 deltas. This is the level at which our average P/L rises and our win ratio increases with greatest velocity. This is the sweet spot between premium collected and win ratio.
For aggressive traders, selling higher delta strangles is attractive because of the premium collected. More conservative traders may want to err on the side of higher win rates by selling smaller deltas. tastylivers want to maximize premium collected without sacrificing win rates. We don’t go for broke, nor do we fear risk. We simply want to find that spot where premium collected justifies the risk taken.
Call it the “tasty spot,” if you will.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, digital asset, other product, transaction, or investment strategy is suitable for any person. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastylive is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer. Options, futures, and futures options are not suitable for all investors. Prior to trading securities, options, futures, or futures options, please read the applicable risk disclosures, including, but not limited to, the Characteristics and Risks of Standardized Options Disclosure and the Futures and Exchange-Traded Options Risk Disclosure found on tastytrade.com/disclosures.
tastytrade, Inc. ("tastytrade”) is a registered broker-dealer and member of FINRA, NFA, and SIPC. tastytrade was previously known as tastyworks, Inc. (“tastyworks”). tastytrade offers self-directed brokerage accounts to its customers. tastytrade does not give financial or trading advice, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastytrade’s systems, services or products. tastytrade is a wholly-owned subsidiary of tastylive, Inc.
tastytrade has entered into a Marketing Agreement with tastylive (“Marketing Agent”) whereby tastytrade pays compensation to Marketing Agent to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. tastytrade and Marketing Agent are separate entities with their own products and services. tastylive is the parent company of tastytrade.
tastycrypto is provided solely by tasty Software Solutions, LLC. tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.