Given that many options traders are seeking opportunities in which they expect implied volatility to revert to the mean, it shouldn't come as a surprise that extremes in the VIX might be indicative of a "rich" trading environment.
But how do different levels in the VIX translate to the bottom line in terms of trade performance?
If you want to learn more about the dynamics of extremes in implied volatility, then a new episode of Market Measures is worth a few moments of your time.
In order to illustrate how different levels in the VIX can impact performance, the Market Measures team designed a study that backtested the performance of a short strangle in SPY across several different volatility environments (differentiated by the value of VIX).
The nuance in this case was that the examination looked at the subtle difference between when VIX is above 20 versus when VIX is above 25. Keep in mind that the VIX has a historical average of about 19. The point therefore, was to try and help quantify “the extra boost” provided by VIX levels that were further above the historical average.
The backtest also included "all trading environments," in order to enhance the across-the-board comparison value of the study.
As you can see in the results below, the average P/L of the short strangle jumped considerably for the occurrences in which VIX was above 25, as compared to the other two scenarios:
On the show, the hosts also explain how the 2008-2009 financial crisis, one of the worst in history, also skewed the averages lower - meaning that excluding catastrophic conditions, the average P/L for short strangles when VIX was above 25 would have been even higher.
The team establishes this point clearly by rerunning the backtest, this time excluding the data from 2008. As presented on the show, this slight tweak saw the average P/L increase considerably, as expected.
For a complete rundown on the findings, we hope you’ll review the entire episode of Market Measures when your schedule allows. It entirely possible your risk profile doesn’t match an environment in which VIX is above 25, but at least this data can aid you in your analysis.
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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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