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Implied Volatility Crush in Apple Highlights Profitable Options Play

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This play is a high-probability-of-success trade that's based on the expansion of implied volatility in Apple as a result of the recent brutal sell-off.

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The purest way to sell option premium in a non directional based trade is to sell a naked strangle. A naked strangle is a position established by selling both a naked put and a naked call. The trade is typically constructed in far out-of-the-money strikes, typically with a delta valued at an absolute value of 5 to 10, and having duration of 25 to 35 days.

I have illustrated below the P&L curve for a 10 lot naked strangle for December monthly options. The put and call are sold at the $475 Put and the $630 Call strikes. The trade has an 87% probability of profitability and yields 9% for a 32 day holding period.



A word of explanation of the manner in which the probabilities are derived is in order. One of the helpful practical characteristics of the options "Greeks" is the fact that the delta of an option is closely correlated to its probability of being in-the-money at expiration.

In the case of the options we are selling, the puts have a delta of -6 and the calls have a delta of 10. This means the puts have a probability of 94% of being out-of–the-money at expiration and the calls have a probability of 90%.

The probability of both contracts being out of the money is therefore 0.9*0.94 = .84 or 84%. The credit we initially received serves to broaden the profitability zone a bit, resulting in the stated 87% probability of profit.

This is a very capital intensive trade with unlimited risk. In the illustrated size of a 10 lot trade, the buying power reduction required in a regulation T account is around $56,000. On this basis, the trade yields 9% at expiration.

For those with risk based margin, more commonly known as Portfolio Margin, the margin is a bit less than half that amount. This dramatic reduction in margin requirements results in a yield in excess of 18%.

These trade constructions illustrate the pure return and probabilities of success for a premium selling approach and illustrate the logical thought process of pursuing such a strategy. An important caveat is that these unlimited risk trades such as illustrated must be taken in small size relative to the total portfolio to reduce risk and allow for adjustments when price does not behave.

While these structures are not common and require a certain degree of capital and professional understanding, the probabilities and potential returns are such that small positions can result in large profitability outcomes on a monthly basis.

Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.

For more on options trading, take a 14 day FREE trial to OptionSmith. Get access to veteran options trader Steve Smith's portfolio along with emailed alerts and strategy with every trade he makes. Learn more.
No positions in stocks mentioned.
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