While 2018 started with some fireworks in terms of volatility, movement in equity markets (at least to the downside) has subsided through the last several months.

Remember at the start of the year when volatility skyrocketed, and short volatility products like XIV and SVXY ran into big trouble? The latter went bust and the former has been on life support since February (the recent reverse split in SVXY isn't fooling anyone).

These events are a good reminder that it's rarely prudent to get significantly short volatility when it's hovering at historic lows. As of this writing, the VIX still sits around 15, which is below its historical average.

The lessons from XIV and SVXY reinforce what Shakespeare wrote so long ago, that "discretion is the better part of valor." In other words, if you aren't sure what's coming, caution is never a bad option.

Keeping that in mind, most traders do like to stay active, no matter the market conditions. The key is to trade smaller, and remain nimble, in the event a big paradigm shift does (finally) occur.

If you want to learn more about such tactics, a new episode of Market Measures is worth reviewing. The focus of the show is defining what "high implied volatility" means, or rather redefining it based on trading environment.

The Market Measures team reiterates on the program that there's nothing like high implied volatility. However, they present research which highlights the fact that environments of heightened implied volatility (IVR > 50%) don't materialize as frequently as we might like.

According to research done by tastytrade, there were about 468 instances (trading days) that IVR was above 50% in SPY from 2005 to 2017. In comparison, there were 3,158 instances in which IVR in SPY was between 20% and 50%.

That means that if you traded only when IVR was above 50%, you’d only be active on about 13% of trading days (468/3626).

Following up on this line of thinking, the Market Measures team decided to backtest the historical performance of a short strangle in SPY when trading across several different trading environments, not only when IVR was above 50%.

Instead, the study examined selling strangles when IVR was greater than 20%, greater than 30%, greater than 40%, and greater than 50%. The results were also separated out by these varying levels of IVR, to help with the side-by-side comparison.

The following parameters were used in building and conducting the study:

  • Backtested short strangles in SPY

  • Utilized historical data from 2005 to 2017

  • Compared selling strangles when:

    • IVR > 20

    • IVR > 30

    • IVR > 40

    • IVR > 50

As you can in the graphic below, the findings revealed that trading in all environments can be profitable (on average), based on historical data:

High IVR

We can see above that our daily average P/L was still positive, even when loosening our definition of "high IVR" to include instances in which IVR was between 20% and 50%.

Certainly, this research doesn’t mean you have to drop your own standards so low when filtering for potential opportunities. It’s entirely possible you only want to be active when IVR is above 50% - that’s completely dependent on your own unique trading approach and risk profile.

Recent research conducted by tastytrade also showed that lengthening duration in low volatility environments is also something to consider. For more information on that topic, we recommend reviewing this previous episode of Market Measures.

If you have any outstanding questions on any of the topics discussed in this blog post, don’t hesitate to leave a message in the space below, or send an email to support@tastytrade.com.

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

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