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Advanced Options Trading Strategies: Generalization, Delta, Strike Selection, and Effect of Volatility

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Marketopedia / Learn about Option Strategies / Advanced Options Trading Strategies: Generalization, Delta, Strike Selection, and Effect of Volatility

Strategy generalization

We can generalize the key strategy levels as below –

  1. Spread = Higher Strike – lower strike
    1. 7500 – 7200 = 300
  2. Max loss = Spread – Net credit
    1. 300 – 42 = 258
  3. Max Loss occurs at = Lower strike price
  4. Lower Breakeven point = Lower strike – Max loss
    1. 7200 – 258 = 6942
  5. Upper breakeven point = Lower strike + Max loss
    1. 7200 + 258 = 7458

– Delta, strike selection, and effect of volatility

We know that this strategy is more profitable in a declining market. To check this, we can do some calculations to determine the delta of the overall strategy.

  • 7500 PE is ITM option, delta is – 0.55. However since we have written the option, the delta is –(-0.55) = +0.55
  • 7200 PE is OTM, has a delta of – 0.29, remember we are long two lots here
  • The overall position delta would be +0.55 + (-0.29) +(-0.29) = – 0.03

The Delta value gives away that the strategy is indeed attuned to changes in the market’s direction (albeit weakly). The negative sign suggests it profits when conditions take a downturn.

I’d recommend that when it comes to strikes, you employ the traditional tandem of ITM and OTM options. Remember, the trade must be done as a ‘Net Credit’. Executing this tactic with a net outflow of cash is not advised.

Let’s look at the variation in volatility and its effect on the strategy –

We can use the three coloured lines to observe the relationship between “premium value” and volatility. This allows us to comprehend how different levels of volatility affect a strategy, while taking time-to-expiry into account.

  1. Blue Line – When the time to expiry is increased and volatility rises, it could be advantageous for a Put ratio back spread. From -57 to +10, the strategy’s payoff increases when volatility goes up from 15% to 30%. This shows that if you are bearish on the stock but have plenty of time before expiry, you would need to consider the degree of volatility as well. Therefore, I might be reticent to implement this approach at the series’ outset with extremely high volatility (higher than twice that of usual).
  2. Green line – This green line shows that an increment in volatility when there are around 15 days left until expiry yields some benefit, though it isn’t as pronounced as previously. We can observe that the strategy return rises from -77 to -47 when volatility rises from 15% to 30%.

Red line – As we near expiry, the premium value does not change too much in spite of volatility increasing. In this scenario, you only need to consider the direction that the security will take and can disregard any fluctuations in its volatility.

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