Short Strangles and Straddles are the widely used neutral option strategies to profit from time value, implied volatility and the directional non-movement of underlying stock. Many traders in India actively do these strategies but not much material available, that I'm aware of, that looked at their historical performance or what could be most optimal settings for these strategies.
In order to attempt to answer some of these questions, in this article, we explore the performance of Short Strangles and Straddles in Nifty and BankNifty index options over past 5 years and try to find optimal parameters that work best with these strategies.
For purpose of the clarity, from here on Short Strangles and Short Straddles will be referred as just Strangles and Straddles respectively throughout the article.
Study of Strangles in Nifty and BankNifty
Short Strangle is a non-directional, premium selling, delta neutral option strategy that involves selling one each out-of-the-money (OTM) strike put and call options. This strategy is profitable when the underlying stock/index stays within the short strikes range, decrease in implied volatility (IV) and finally passing of the time (Theta depreciation). A typical Strangle pay-off chart is depicted in the graph below
In this section, we will examine the performance of strangles in Nifty and BankNifty options over past 5 years encompassing 60 trades (N=60), one trade each per expiry contract. All the data used here is end-of-day (EOD) options data downloaded from NSE BhavCopy.
Strangles in Nifty
In this back-testing study, we will place strangles on Nifty options and sell OTM put and call options whose strike price is one standard deviation (SD) away. By definition, standard deviation quantifies the deviation of a set of data from its mean. In financial terms, one standard deviation encompasses 68.2% of the range within which stock moves in a year assuming it follows a Normal (or Gaussian) distribution.
One standard deviation move is calculated using Nifty spot price, IV and days to expiry (DTE) as the inputs using the following formula
In the next step,we will place strangles with different variations to see the effect of time, effect of earlier exit and effect of implied volatility (IV).
Days to Expiry (DTE)
In this step, we will place four different strangles with different days to expiry to measure the effect of time (or Time of Entry) on the profitability. We will place strangles with 15, 30, 45 and 60 days to expiry (DTE) for every expiry contract and hold them till the expiry. To calculate the Profit & Loss (P&L) of the strategy, we subtract the premium left at the end of the expiry day from the credit received for selling the strangle at the beginning.
The results of this strategy are tabulated and presented in the table below
The values highlighted in the orange are the best values obtained for the strangles option strategy.
Winning percentage (or win-rate) tells about the number of times the strangle strategy was profitable over the total number of trades. Average P&L shows the average profit gained or loss incurred over all the trades. Average Profit tells about the average profit among only the profitable trades while Average Loss tells about average loss incurred among only the loss-making trades. These values tells us what one can expect on an average when a trader enters a one SD strangles in Nifty options.
In the same way, Max. Profit tells about the maximum profit obtained in a specific trade among all the trades while Max. Loss tells about the maximum loss incurred in a particular trade among all trades. These values tells us about the extremes of profit or loss that were observed in strangle strategies over the past 5 years.
Since the four strangles are held for different periods of days, the best metric & important criteria to gauge the performance of a particular strategy will be Average P&L Per Day which is the average profit gained or loss incurred on a per-day basis.
Among the four strategies, 45 DTE strangles performed better in terms of win rate, average P&L per day and maximum profit in a trade. And therefore, one can conclude that 45DTE is most optimal strangle strategy to enter & hold till expiry if these results holds true in the future as well.
Earlier Exit of Strangles
It is known that options experience a 'Gamma Risk' in the last weeks of expiry contract. Gamma is an option greek that tells us about how the movement of the underlying stock influences the delta of the option. A higher gamma results in higher delta and therefore more sensitivity of option price to the underlying movement. In short, a higher gamma (Gamma Risk) results in option price moving more swiftly and drastically in relation to underlying and can lead to quick losses if underlying moves against the trade.
If we were to avoid this "Gamma Risk' by exiting the strangles two weeks earlier than the expiry date of the option contract, can we see any gains compared to holding them till the expiry. To answer this question, we enter 30, 45 & 60 DTE strangles but instead of holding them till expiry, we will exit the strangles 15 days earlier. Below are the tabulated results of this variation.
One significant observation here is that both Avg. Loss and Max. Loss decreased across the board compared to strangles held till expiry. Though this has reduced Avg P&L and Avg. Profit due to fewer number of days the strangles are held, the Avg. P&L per day has vastly improved over strangles held till expiry. These results show that by avoiding gamma risk, the Avg. P&Ls per day are boosted by reducing the losses in the final weeks of the expiry.
Here as well, 45DTE strangles performed well compared to 30DTE & 60DTE strangles.
From these results, once can conclude that entering 45DTE strangles and exiting 15 days before expiry is more optimal strategy compared to others.
Effect of IV on Strangles
Implied Volatility is a metric to measure the volatility of an underlying stock as implied by the options. A high IV (or volatility) is a result of high demand for options by traders/speculators betting on a sharp movement in the underlying stock.index. This results in richer premiums in the options. And therefore, short strangles will receive higher credit than usual and also wider break-evens thus increasing the probability of trade being more profitable and successful.
In this context, we can examine if high IV leads to more profitable & successful trades or not. To check this, we choose only those strangles when the IV Percentile (a proxy for high IV) is greater than 60 and then exit 15 days before the expiry. Here are the tabulated results of the strangles placed during high IV environment compared with strangles placed irrespective of IV.
Green arrows in the table represent improvement in strangles performance under high IV environment while red arrows show decrease in performance. N is the number of trades in the study.
From the results its clear that only 30DTE strangles showed improvement in Average P&L per day from 32 to 46 while 45DTE and 60DTE strangles showed marginal decrease in performance. Given these results, one can observe that 45 DTE& 60DTE are far away from the expiry day to have their option prices to be sensitive to underlying index volatility in addition to option strikes being OTM. As a result, high IV doesn't have the same influence on the 45DTE & 60DTE like it has on 30DTE option prices.
Takeaway of Strangles in Nifty
The three takeaways after observing the results of the effect of three different variables on Strangles - time to expiry, earlier exit and high IV are
- 45 DTE is a more optimal strangle compared to others
- Exiting strangles 15 days before expiry boosts the profitability by cutting losses as a result of avoiding gamma risk in last weeks of expiry
- High IV has positive effect on lower DTE strangles like 30DTE and have no influence on the performance of higher DTE strangles but overall nothing very conclusive on this front.
In conclusion, 45DTE strangle & exiting 15 days before expiry is the most optimal strategy to place for good profitability in Nifty strangles.
Strangles in BankNifty
Similar to Nifty strangles, we place one standard deviation BankNifty strangles with three different variations to find an optimal strangle strategy.
Days To Expiry(DTE)
Four different strangles with 15, 30, 45 & 60 DTE are placed & held till expiry. Results are tabulated below
Results clearly show that 45DTE BankNifty strangle is more optimal compared to other DTE strangles. 45 DTE shows better Avg. P&L, Avg. Profit and Avg. P&L Per Day values.
Exit Strangles 15 days before Expiry
In this step, we test for the performance of 30, 45 & 60DTE BankNifty Strangles where we exit them 15 days before expiry. Results are tabulated as shown below.
As seen in the results, all strangles have shown improved performance compared to strangles that were held till expiry.
Though all DTE strangles show equal win rate, the real improvement in performance came in the case of 30DTE strangles with Avg. P&L per day almost tripling from 124 to 344. The improved performance of the strangles came on the back of reduction of Avg. Loss as a result of cutting off of the gamma risk in the final weeks of expiry.
Though 45DTE has performed well in most metrics, the better performing strategy is 30DTE strangle with a better Avg. P&L per Day.
Effect of IV on BankNifty Strangles
Here, we place 30, 45 & 60DTE BankNifty strangles when IV percentile (IVP) is greater than 60 and exit 15 days before expiry. Results are shown in the table below
Strangles placed under high IV environment show slightly better performance in 45DTE & 60DTE strangles but show a vast under-performance in 30DTE strangles. This result is quite opposite to the results observed with Nifty strangles placed when IVP is greater than 60.
Results from both Nifty & BankNifty strangles with IVP>60 show that high IV has highly variable effect on strangles performance and therefore no conclusion can be made with this parameter with respect to strangles.
Takeaway of Strangles in BankNifty
The three takeaways from the back-test on BankNifty strangles are
- 45 DTE is a more optimal strangle compared to others when held till expiry
- Exiting strangles 15 days before expiry boosts the profitability by avoiding gamma risk in last weeks of expiry and 30DTE BankNifty strangles perform better than 45DTE in this condition
- High IV has positive effect on higher DTE strangles but just as with Nifty Strangles, here also high IV has no conclusive effect on strangles.
In conclusion, 45DTE strangle when held till expiry & 30DTE strangle when exited 15 days before expiry are the most optimal strategies under those conditions to place for good profitability in BankNifty strangles.
Study of Straddles in Nifty and BankNifty
Short Straddle is a non-directional, premium selling, delta neutral option strategy that involves selling one each at-the-money (ATM) strike put and call options. This strategy is profitable as the time passes and the underlying stock/index stays within the breakeven range and when implied volatility (IV) decreases. A typical Straddle pay-off chart is depicted in the graph below
In this back-test, we will examine the performance of straddles in Nifty and BankNifty options over past 5 years encompassing 60 trades (N=60), one trade each per expiry contract.
Straddles in Nifty
We will place Straddles in this back-test by selling one each of ATM strike put and call option and test them with various parameters such as days to expiry (DTE), managing exit of trades 15 days before expiry and finally placing straddle under high IV conditions.
For each straddle strategy, we calculate profit and risk metrics such as win-rate, Avg. P&L, Avg. profit, Avg. Loss, Max. Profit, Max. Loss & Avg. P&L per Day. These metrics will help in better understanding the performance & comparison of different straddle strategies.
Nifty Straddles with various DTEs
Here, we place straddles with 15, 30, 45 & 60 DTE and hold it till expiry. Below are the results for these straddles
Straddles usually have a probability of profit (POP) of around 60% and is getting reflected in these straddles win-rate barring 30DTE which has vastly under performed. Results show that 45DTE straddles seem to be the optimal strategy if held till expiry compared to other DTEs. It has the highest win-rate, best Avg. P&L and most importantly a better Avg P&L per Day.
Nifty Straddles exited 15 says before Expiry
In this particular back-test, we enter 30, 45 & 60 DTE straddles and exit 15 days earlier instead of holding till expiry to avoid gamma risk.
There is an increased performance across all DTE straddles with a clear boost in Avg. P&L per Day. Once again, it is apparent that avoiding gamma risk improves success, profitability and risk metrics as exemplified by better win-rate, increased Avg. P&L and a reduced Avg. Loss. Among all the DTE straddles, 45DTE again performed better on most metrics and therefore an ideal straddle to place compared to others.
Nifty straddles with IVP>60
We check the effect of IV on Nifty straddles by choosing to place them when Nifty IV Percentile is greater than 60. The straddles are then exited 15 days before expiry. Results of this test are compared to the DTE straddles that were placed irrespective of IV environment.
As opposed to Nifty & BankNifty strangles with IVP>60, the Nifty straddles placed under high IV conditions have shown across the board improvement in profitability as seen in the Avg. P&L per Day. This stark difference between strangles and straddles can be ascribed to the fact that the ATM options sold in the straddle are more sensitive to high IV compared to OTM options sold in the strangle. As a result of this, high IV leads to relatively more credit being received by the straddles than strangles and therefore a marked difference in performance of straddles under high IV conditions compared to strangles.
Here as well, 45DTE straddles outperformed others and seems to be well placed as an optimal straddle strategy.
Takeaway of Straddles in Nifty
The three takeaways from the back-test on Nifty straddles are
- 45 DTE is a once again a more optimal straddle compared to other DTEs when held till expiry
- Earlier exit of straddles boosts the profitability by avoiding gamma risk.
- High IV has a more conclusive positive effect on the profitability of straddles
In conclusion, 45DTE straddle placed when IV Percentile is above 60 and when exited 15 days before expiry is the most desirable & profitable straddle strategy in Nifty.
Straddles in BankNifty
In this step, we will place BankNifty straddles suing same parameters used in placing the Nifty straddles and observe the results.
BankNifty Straddles with various DTEs
We enter 15, 30, 45 & 60DTE straddles & hold them till expiry.
Compared to Nifty straddles there is vast under performance of BankNifty Straddles when held till expiry. The only exception being 60DTE straddles. The under performance of BankNifty straddles can be attributed to the fact that BankNifty being a more volatile instrument than Nifty is more prone to accumulating losses due to gamma risk during the fag end of expiry.
If this hypothesis is true, there should be marked improvement in BankNifty straddles if they avoid the gamma risk by exiting earlier
Exiting BankNifty Straddles 15 days before Expiry
15, 30, 45 & 60DTE straddles are placed and exited 15 days earlier than the usual exit during expiry.
As hypothesized in earlier section, taking away gamma risk has instantly boosted profitability of all BankNifty DTE straddles by almost 3 times. The gain in performance in BankNifty straddles outpaced gains in Nifty Straddles when exited 15 days earlier. This illustrates the point that BankNifty, being a more volatile instrument than Nifty, stands to gain more by avoiding gamma risk than Nifty.
From all the metrics observed in BankNifty straddles, 60DTE straddle seems to be a better performing straddle compared to others.
BankNifty straddles with IVP>60
30, 45 & 60 DTE straddles are placed when IV percentile (IVP) is greater than 60 and exited 15 days before expiry.
There is a vast improvement in the win-rate and profitability of BankNifty 45DTE & 60DTE straddles when placed under high IV conditions. In this condition, 45DTE straddle outperformed 60DTE in terms of profitability.
The decrease in performance of 30DTE straddles can be attributed to an outlier effect of missing a trade with max. profit (Rs 49518) which itself points to the caveats of smaller sample size in these studies.
Takeaway of Straddles in BankNifty
The three takeaways from the BankNifty straddles back-test are
- 60 DTE is a more optimal straddle compared to other DTEs when held till expiry
- And 60 DTE as well other straddles perform even better when straddles are exited earlier to avoid gamma risk
- High IV has boosted the profitability of straddles
In conclusion, both 45DTE & 60DTE straddles placed when IV Percentile is above 60 and when exited 15 days before expiry are the most ideal straddle strategies in BankNifty.
Observations and Conclusions
In this back-test study of Strangles and Straddles of Nifty and BankNifty, I tried to find the most optimal strategy and parameters to be used in our trading using past 5 years of end-of-day historical options data. We tried to see the effect of various parameters such as time of entry, time of exit (gamma risk) and implied volatility on the performance of the strangles and straddles.
Following are some of the significant observations & conclusions that came out of this study.
Effect of Entry Time
Entry time seems to be an important element of these strategies to be profitable. Entering earlier gives more theta premium and therefore more credit received which increases the envelope of break-evens and thus increase the chance of success.
Results from the study clearly show that placing strangles & straddles much earlier is more rewarding than a standard 30DTE strategies that are placed during expiry roll-over. Among these, 45 DTE seems to be the most optimal time of entry to place both strangles and straddles. In case of BankNifty straddles, even 60DTE has performed well.
Effect of Early Exit
We wanted to see what would happen if the strangles & strategies are managed earlier to avoid gamma risk by exiting them 15 days before expiry.
As expected, exiting the strangles and straddles earlier has boosted profitability by cutting the losses due to avoidance of gamma risk. Though we have tested the exit criteria 15 days before expiry, one can surmise that this can hold true for 10 days as well. Hence, entering early and exiting early in these strategies is more beneficial than entering late and exiting late.
Effect of Implied Volatility
Implied Volatility (IV) is one of the major component in the pricing of options. Uncertainly & high expectation surrounding an event leads to high IV among the options of the underlying stock. This gets reflected as richer premiums in option prices and thus more credit is received by the strangles and straddles than during normal uneventful days. This makes the break-evens of strangles and straddles wider thus increasing the probability of success.
To test this, we placed strangles and straddles only when IV was higher (IVP >60). Both Nifty and BankNifty Straddles have shown improved performance when placed under high IV environment but this effect was not seen in strangles more conclusively.
The improved performance of straddles could be due to higher credit received as a result of higher sensitivity of ATM option prices to high IV. This hypothesis needs to be thoroughly tested to see if any other variable affecting this phenomenon.
Strangles vs Straddles
When the performance of optimal strangles of both Nifty and BankNifty are compared to optimal straddles, the strangles show high win-rate of above 80% but low profit potential but has lower magnitude of losses. On the other hand, straddles show relatively lower win-rate of around 70% but much higher profit potential and at the same time more riskier due to high max. losses.
Strangles and straddles follow the maxim "No Risk No Reward". Strangles have lower risk, higher win-rate but lower profit potential while straddles have high risk, relatively low win-rate but higher profit potential. Traders should place strangles or straddles according to their risk-appetite - strangles for lower but less risky returns and straddles for higher but more risky returns. The results tables show what are the maximum possible losses and profits seen in these strategies during the past five years, so one can make an informed decision on which strategy suits best.
Nifty vs BankNifty
When the performance of Nifty and BankNifty strategies are compared, the profit potential of BankNifty seems to be higher and this can be simply attributed to the fact that BankNifty is more volatile compared to Nifty and therefore more risk premium paid on such instruments by the option buyers. This results in relatively more credit received in BankNifty strategies and gets reflected in the profit potential.
We need to test this hypothesis by comparing other low volatile and high volatile stocks to confirm this assumption more definitively.
Implied Volatility vs Real Volatility
One standard deviation strangles by definition have a theoretical probability of profit(POP) of around 68% but in practice when we place optimal strangles, the POP gets boosted to 80% and more. In the same way, straddles have a theoretical POP of around 55-60% and in practice when optimal straddles are placed, the POP improves to 70% and above.
These observations states the fact that implied volatility of the stock most of the times overstates real volatility and a trader should try to capture this difference to make the option selling strategies more profitable.
Of course, there are many more parameters that can be tested to find even more optimal settings. The parameters such as managing winners, managing loss making trades, choosing of strangle strikes, effect of volatility skew etc can be further explore in future articles.
In the next article, we will look at the strangles and straddles of stock options.