Delta represents a few things, including the chance that the option will expire in-the-money (ITM). Two times the Delta is roughly the Probability of Touch (POT), which is the chance the strike in question will be at-the-money (ATM) or ITM at any time before it expires. As Tom put it, “Opportunity is two times the chances of sustainability. The chances of something touching something is two times the chances of something happening and staying there.“ What would a study reveal about the chances that an underlying will touch (not close) above the current price at a certain price in a certain duration?
Our study was conducted in the SPY (S&P 500 ETF) using data over the past 20 years to determine how often the 1 Standard Deviation (SD) Strangles expired ITM or touched either strike before expiration.
A table of the results since 1995 and 2014 to present compared the theoretical and actual numbers of the SPY Strangles probability of expiring ITM and the probability of touching either short strike of the Strangle. In both cases the theoretical probabilities were around double the actual numbers. This is because Implied Volatility (IV) overstates actual volatility.
Since there is a fairly high chance that a strike will be touched during the lifetime of the option does this mean we can make money by purchasing options and sell them when the strike is touched? Not likely, because Theta (time decay) will work against you and a contraction in IV would further hurt.
Two examples were used to explain why going long premium does not work. The first example was buying a Strangle in SPY ($212 Put and $218 Call) at a 4.85 debit and a 15.5% IV on November 9th. On November 17th the SPY was higher and traded up to $219.06 while IV contracted to 13%. Despite the up move the Strangle was a loser. The second example which from October 1st, to November 16 showed that the move occurred too slowly for the long Strangle to show a profit.
Tom added, “We sell a lot of premium and have the philosophy here at tastylive of letting the market beat us. Actual Volatility has a tendency to under perform theoretical Volatility because fear is always overpriced. So we set up a methodology that says, let the market beat us.”
Watch this segment of Options Jive with with Tom Sosnoff and Tony Battista for the important takeaways, the results of our study on probability of touch (POT) and why going long options based upon the result is a flawed strategy
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