Market Efficiency Test [IWM vs SPY Study]

Key Concepts

• IV Adjusted Notional Value: A method to normalize options positions by accounting for their implied volatility, allowing for a fair comparison of risk and return between different underlyings.
• 16 Delta Strangle: An options strategy involving selling both a put and a call option with a delta of approximately 16, typically used for income generation.
• Win Rate: The percentage of trades that result in a profit.
• Average P&L (Profit and Loss): The average profit or loss generated per trade.
• Volatility of P&L: The degree of fluctuation in the profit and loss of a trading strategy, indicating the consistency of returns.
• SVAR (Covariance of Risk): A measure of tail risk, specifically looking at the 5% worst-case scenarios.
• Average Premium per Trade: The average amount of premium collected on each trade.
• Buy to Premium to Buying Power: A metric that relates the premium collected to the capital required to hold the position.
• Max Loss: The maximum potential loss on a trade.
• Implied Volatility (IV): The market's expectation of future price fluctuations of an underlying asset, as reflected in option prices.
• Arbitrage: The simultaneous purchase and sale of an asset in different markets to profit from a price difference.

Study Methodology and Data

The study aims to compare trading IWM (iShares Russell 2000 ETF) and SPY (SPDR S&P 500 ETF) by keeping variables constant, primarily through the use of IV adjusted notional value. This normalization is crucial because different underlyings can have significantly different implied volatilities, leading to varied premium collection for taking on similar levels of risk.

The study period spans from 2020 to the present, covering approximately five years of data. The strategy employed is selling the 16 delta strangle in both IWM and SPY. The typical timeframe for these trades is 45 days to expiration, with management at 21 days.

The following metrics were recorded and analyzed:

• Win rate
• Average P&L
• Volatility of the ending P&L (highlighted as an often-overlooked metric for assessing trade sustainability)
• SVAR (covariance of risk, focusing on 5% tail risk)
• Average premium per trade
• Buy to premium to buying power
• Max loss
• Ratio of each metric

IV Adjusted Notional Value Calculation

To ensure a fair comparison, the study accounts for the difference in implied volatility between IWM and SPY. The core principle is that a higher implied volatility means more premium is received for taking on risk.

• Example: If one stock has 50% implied volatility and another has 10%, the former offers significantly more compensation for risk.
• Study Specifics: For the study, two theoretical contracts in IWM were considered against one contract in SPY. This weighting is based on the IV adjusted notional value, which was found to be approximately a 2:1 ratio (SPY to IWM).
• Calculation Formula: The transcript mentions a formula for IV adjusted notional value: Underlying Price * 100 * Implied Volatility. This calculation normalizes the notional value of the options positions.
• Underlying Prices and IVs: At the time of the study, IWM was trading around $236 with an implied volatility of approximately 27-30%, while SPY was trading around $670 with an implied volatility of about 20%. This difference in IV contributes to the need for adjustment.

Comparative Analysis of IWM vs. SPY

Win Rate

• Finding: After adjusting for IV notional value, the win rates for IWM and SPY were found to be nearly identical, ranging from 71% to 72%.
• Interpretation: This suggests that the deltas are priced efficiently across these different products. The speaker emphasizes that markets are efficient, and when adjusted to a common denominator (IV adjusted notional value), similar ETFs like IWM and SPY show comparable win rates, regardless of individual ticker sentiment. This supports the idea that implied volatility reflects the pricing of risk.

Premium and Volatility

• Finding: IWM offers higher premiums but comes with much greater volatility in its P&L. SPY, on the other hand, is more stable with similar win rates.
• Interpretation: This is a direct consequence of IWM's higher implied volatility. Higher volatility leads to wider ranges in P&L distribution and greater potential for both larger profits and larger losses. The speaker notes that while IWM pays more, the increased volatility means a trader must be able to withstand larger swings to stay in the position.

Risk-Reward Ratio

• Finding: The ratio of risk-reward for these strategies is comparable when everything is adjusted to implied volatility. The actual historical figures for IWM versus SPY, when IV adjusted, show remarkably similar metrics.
• Interpretation: This reinforces the concept of market efficiency. When positions are normalized for implied volatility, the risk-reward profile becomes essentially the same. The speaker states that there is no arbitrage available, meaning that for higher returns, one must accept proportionally higher risk. There are no "free lunches" in the market.

Key Arguments and Perspectives

• Market Efficiency: The central argument is that markets, particularly liquid underlyings like IWM and SPY, are efficient. Implied volatility plays a key role in pricing risk, and when adjusted for, different products offer comparable risk-reward profiles.
• Importance of IV Adjustment: The transcript strongly advocates for using IV adjusted notional value when comparing options strategies across different underlyings. This method provides a fair and accurate comparison of risk and return.
• Beyond Dollar P&L: The speaker stresses the importance of looking beyond just the total dollar amount of profit. The volatility of the P&L is a critical factor in determining a strategy's sustainability and a trader's ability to remain in a position.
• No Arbitrage: The absence of arbitrage opportunities is highlighted. Any perceived advantage in returns is directly matched by an equivalent increase in risk.
• Managing Expectations: The discussion on risk and return leads to the conclusion that traders must align their expectations with the risk they are willing to take. Lowering expectations is necessary if one is unwilling to accept higher risk.

Notable Quotes

• "Beyond similar price movements, is there an advantage of trading one product over over the other? In order to test this fairly, we have to keep many variables constant. And this involves normalizing through the use of IV adjusted notional value for our options."
• "A lot of people just look at the dollar and say, 'Oh, well, this one's better than this one because you made more money.' Well, you got to look at like the volatility of the P&L and how big those swings are because that's going to tell you if you can actually hold that position and and stay in it."
• "When you adjust everything to make them the same sort of denominator, everything turns out the same."
• "It doesn't matter if it's IWM or SPY, if they had the same exact implied volatility and the and the same um price, you're going to have the same sort of results out of these these figures."
• "Riskreward is efficiently priced in liquid underlyings."
• "For a product with higher returns, your risk is matched almost one. If you want more returns, you have to take more risk. No free money."

Practical Implications and Actionable Insights

• Trading Ratios: For a strategy involving selling strangles, the study suggests a potential trading ratio of six IWM strangles for every three SPY strangles to maintain a comparable risk profile, based on the observed IV adjusted notional value. The speaker believes this ratio is likely to remain relatively stable for large market ETFs.
• Focus on IV: When evaluating trading opportunities, consider the implied volatility of the underlying as a key indicator of the risk-reward trade-off.
• Holistic Performance Metrics: When backtesting or evaluating strategies, incorporate metrics like P&L volatility and SVAR, not just average P&L, to understand the true risk profile and sustainability of a strategy.

Conclusion

The study demonstrates that when options positions are normalized for implied volatility, the risk-reward profiles of IWM and SPY, when trading the 16 delta strangle, are remarkably similar. While IWM offers higher premiums due to its higher implied volatility, this comes with increased P&L volatility. SPY provides a more stable, albeit lower, premium. The core takeaway is that markets are efficient, and risk and reward are intrinsically linked; there are no shortcuts to higher returns without taking on commensurate risk. Traders should focus on understanding and managing this risk-reward balance, rather than seeking an inherent advantage in one underlying over another based solely on price movements.