Probably our most common strategy when selling premium is the short Strangle. When it goes wrong we first react by rolling the untested side towards the other side and sometimes we roll the trade out in time. Our final defensive maneuver is to go inverted in which our short Call is at a lower strike than our short Put and both are in-the-money (ITM). Because the extrinsic value of in-the-money options mimics that of the out-the-money options (OTM) at the same strikes some viewers have asked about placing the inverted position as the initial trade. How would that perform?
An example comparing a short Strangle to an Inverted Strangle in XYZ stock trading at $100 was displayed. The example showed that although the Inverted Strangle collects a sizable premium as compared to the short Strangle, but most of that is just intrinsic value. The extrinsic value and the max profit are the same.
Tom asked Tony, “What would be the advantage to using OTM options in a short Strangle as compared to the disadvantage of using ITM options of the inverted Strangle? Tony answered that there is dividend risk, early assignment risk as well as a wide Bid-Ask Spread differential to the ITM options.”
Our study was conducted in the SPY (S&P 500 ETF) using data from 2005 to the present. We used the options expiration cycle closest to 45 days to expiration (DTE) and compared shorting the ½ Standard Deviation SD) Strangle comprised of a short 30 Delta Put and a short 30 Delta Call to an Inverted Strangle in which we used the same strikes but switched the Put for a Call and the Call for a Put. We managed at 50% of max profit if possible or held to expiration.
A table of the results compared the average credit received, success rate and average P/L on both the short SPY Strangle and the Inverted Strangle. At first glance both Strangles had the same success rate. However on average the Inverted Strangles seem to have a higher average P/L. The question is why? The answer is that the Inverted Strangle had a higher extrinsic value because of wider bid-ask spreads which led to less accurate mid-prices and the SPY quarterly dividend impacted the prices of the ITM Calls. Another point in distinguishing the two is the early assignment risk involved with ITM options which can affect P/L and trade consistency.
For more information on Inversion see:
From Theory To Practice from June 13, 2016: "Inverted Adjustments"
Best Practices from July 5, 2016: "How To Get Inverted"
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and the detailed results of our study comparing Short Strangles using OTM options to Inverted Strangles using ITM options, which is preferable and why one strategy poses an unnecessary risk to you the trader.
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