Market Measures

The Contraction Factor

| Feb 17, 2015
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    Market Measures

    The Contraction Factor

    Feb 17, 2015

    A common question we’re often asked is whether volatility expands or contracts faster? Also, if volatility contracts quickly, is it possible to use a shorter cycle to place a trade when IV is high? Today, Tom Sosnoff is joined by crowd favorite Tom "TP" Preston as they examine the data around these questions.

    First, the guys find out that summarize a quick study that analyzes the velocity of down moves in volatility. They do this by looking at a basket of major market exchange traded funds (ETFs) when they had occurrences of implied volatility rank (IVR) greater than 80% over the past five years. From here, the study shows how long it takes, on average, to see a drop of 10 points, 15 points, and 20 points in IVR (from 80 to 70, 65, and 60 respectively). The results show it takes 3.64 days for 10 points, 5.71 days for 15 points, and 6.75 days for 20 points.

    Because it takes, on average, less than seven days for these ETFs to fall 20 points from an implied volatility rank of 80, does this merit placing a trade with a shorter time frame when we have this extremely high IVR?

    To test this, a study is set up looking at occurrences of implied volatility over the 80 rank for the last five years. The ETFs included in the study were EEM, EWZ, GLD, SPY, TBT, USO, XLE, XRT. In these underlyings, the team simulated selling 1 standard deviation strangles in two different cycles, 15 days to expiration (DTE) and 45 DTE. The trades were tracked to observe when a strangle could be bought back for a 50% winner.

    The study finds that both the strategies are profitable with strong results and high win rates for both the 15 and 45 DTE strangles. The takeaways from this segment are pretty clear, primarily that the velocity of the contraction in implied volatility does allow for scaling using shorter expiration cycles.

    Additionally, by managing winners, the study showed 80% of the total expiration profit was collected in half of the time.

    This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.

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