The IV risk with short strangles

[MrAgi1]

Why is it that most often when people talk about the risk of a short strangle, it is mostly only mentioned that price moving outside the strike and breakeven points causes losses?

To me the biggest risk is IV exploding(maybe due to a sudden event like a pandemic, political crisis or a disaster). In theory IV could keep rising and my losses keep on piling up and up even without price moving outside my wide range strangle. This could wipe out years of hard earned profits. I am not sure how that is an efficient way to trade.

What do you think, or am I getting something wrong?

 

[MacBookProHo]

This could wipe out years of hard earned profits
I am not sure how that is an efficient way to trade.

What do you think,

A trader's strength is only as strong as his weakest link. If there are landmines on the horizon for you, it's practically a guarantee you'll get blown away.

A trader's weakest link is only as strong as his strongest link....it helps to have a strong, powerful, offensive strategy and skill as well.
Having a strong defense but a rather lackluster offense will make your account rather impotent and limp.

What do I think....it helps to generally know the future in trading. and options can be your friend, if you formulate it to be.

 

[BlueWaterSailor]

Any strategy can "wipe out years of profits" when done wrong. "Buh buh buh buying calls/puts! Fixed risk, no?" Not when you max out your account on those and lose it all on a single bet, no. "But what about blah blah blah strategy?" Same thing, no matter what you do; it's all risk based on possible rewards. Any strategy can be applied stupidly; the reason they exist is because they can also be applied intelligently.

For any reasonably-sized account, a 5-wide strangle in, say, $F has exactly zero chance of "wiping out years of profits". The largest daily move for it over the past 20 years is less than $1.50, and the vol spikes are all momentary. And yet, selling 1k lots of it in a $150k account would likely be a really stupid move.

Strangles make sense if they fit your view of the underlying and the relevant volatility - AND they are appropriately sized to your account and your risk appetite. Looking at any strategy in isolation without considering all of those factors, is simply not rational.

P.S. Options allow you to express, with some degree of precision, your view on an underlying and its vol. If you're right in that view and its expression, it doesn't matter how "risky" a given strategy may look on paper. I would willingly bet a significant percentage of my account on a single trade - IF the right odds came along.

And no, vol is not this magical Thing that can just randomly explode without any reason or price changes. Like most other things in this business, it has a standard distribution and computable risks (which includes outliers.) No, it's not easy; no, it's not trivial. But people have been making money on it for a long, long time now - so it is possible.

 

[panzerman]

And no, vol is not this magical Thing that can just randomly explode without any reason or price changes. Like most other things in this business, it has a standard distribution and computable risks (which includes outliers.) No, it's not easy; no, it's not trivial. But people have been making money on it for a long, long time now - so it is possible.

Price is lognormally distributed with some amount of skew and kurtosis. The thing is, skew and kurtosis are themselves stochastic. Therefore, implied volatility is stochastic. Nobody has a good stochastic volatility model. If they did, selling options only would be an almost sure bet to riches. I'm sure LTCM and Supertrader Karen both ring a bell. Anyone know how Max Ansbacher has faired recently?

 

[BlueWaterSailor]

Price is lognormally distributed with some amount of skew and kurtosis. The thing is, skew and kurtosis are themselves stochastic. Therefore, implied volatility is stochastic. Nobody has a good stochastic volatility model.

There's an old joke about a market maker who saw a $100 bill on the ground and walked right by it. When asked why, he said "it's obviously fake - if it had any value, somebody would have already picked it up!"

Have you ever actually traded an option, @panzerman? Not in the classroom, not paper-trading, but using real money? If you have, then you already know that your argument is false. You even know why. The only thing that's unclear is why you'd post this kind of ivory-tower naivete here, or why - other than you being conscious of being wrong and trying to bolster yourself with fake arguments - you'd pick only failures as your examples. Trying to demonstrate some sort of a shallow erudition, perhaps?

Here, have some particularly apropos food for thought:

"Option hedging, pricing, and trading is neither philosophy nor mathematics.
It is a rich craft with traders learning from traders (or traders copying
other traders) and tricks developing under evolution pressures, in a
bottom-up manner. It is technë, not ëpistemë."
-- Nassim Nicholas Taleb

And yes, I understand stats just fine. But "stochastic" doesn't mean "arbitrary", and "nobody has a good model" doesn't mean "nobody has a model", or even "nobody has a model they use to trade". And not having a perfect answer doesn't mean that a Nash equilibrium does not exist, either.

P.S. Just did a quick search, and - ah. You're a TA trader who rarely if ever trades options. Yeah, that would explain the attitude.

 

[ETJ]

https://ansbacherusa.com/

Hasn't made any money in 22. Which really isn't poor, but hasn't had any real performance in a while. Teachable performance. You can see the stats.

 

[BlueWaterSailor]

https://ansbacherusa.com/

Hasn't made any money in 22. Which really isn't poor, but hasn't had any real performance in a while. Teachable performance. You can see the stats.

Interesting. Although I found this pretty entertaining:

 

[earth_imperator]

Why is it that most often when people talk about the risk of a short strangle, it is mostly only mentioned that price moving outside the strike and breakeven points causes losses?

To me the biggest risk is IV exploding(maybe due to a sudden event like a pandemic, political crisis or a disaster). In theory IV could keep rising and my losses keep on piling up and up even without price moving outside my wide range strangle. This could wipe out years of hard earned profits. I am not sure how that is an efficient way to trade.

What do you think, or am I getting something wrong?

Yes, you are wrong. They talk of the situation at expiration, whereas you talk of the situation before expiration.
You simply have to know this simple & important fact:
At expiration the IVs don't matter! As then only the price of the underlying matters.
You can convince yourself by studying the PnL diagram of short strangle, for example here.
In the lower part watch that the final outcome at expiration (ie. the orange line) doesn't change when you change the Volatility.... The blue line does change, but the blue line represents the situation on the "Days from Today" setting, which is before the expiration day...

Hope this clears the confusion

 

[newwurldmn]

Interesting. Although I found this pretty entertaining:

View attachment 295961

basically their risk mitigation strategy is being a limited liability corp!

 

[BMK]

basically their risk mitigation strategy is being a limited liability corp!

That's an interesting observation, but it is functionally very similar to buying shares in a fund that uses derivatives. The fund may hold positions that have theoretically unlimited risk, such as naked short calls or short futures contracts. But shareholders are not personally liable.