ity. This means that negative-gamma traders had better be good and had better be right!
In this situation, hedgers and speculators in the market are buying option volatility of 50 percent, while the stock is moving at 35 percent volatility. Traders putting on adelta-neutral volatility-selling strategy are taking the stance that this stock will not continue increasing in volatility as indicated by option prices; specifically, it will move at less than 50 percent volatility—hopefully alot less. They are taking the stance that the market’sexpectations are wrong.
Instead of realized and implied volatility both trending higher, sometimes there is asharp jump in one or the other. When this happens, it could be an indication of aspecific event that has occurred (realized volatility) or news suddenly released of an expected event yet to come (implied volatility). Asharp temporary increase in IV is called aspike, because of its pointy shape on the chart. Aone-day surge in realized volatility, on the other hand, is not so much avolatility spike as it is arealized volatility mesa. Realized volatility mesas are shown in
Exhibit 14.2
.
EXHIBIT 14.2
Volatility mesas.
Source
: Chart courtesy of
iVolatility.com
The patterns formed by the gray line in the circled areas of the chart shown below are the result of typical one-day surges in realized volatility. Here, the 30-day realized volatility rose by nearly 20 percentage points, from about 20 percent to about 40 percent, in one day. It remained around the 40 percent level for 30 days and then declined 20 points just as fast as it rose.
Was this entire 30-day period unusually volatile? Not necessarily. Realized volatility is calculated by looking at price movements within acertain time frame, in this case, thirty business days. That means that areally big move on one day will remain in the calculation for the entire time. Thirty days after the unusually big move, the calculation for realized volatility will no longer contain that one-day price jump. Realized volatility can then drop significantly.
2. Realized Volatility Rises, Implied Volatility Remains Constant
This chart pattern can develop from afew different market conditions. One scenario is aone-time unanticipated move in the underlying that is not expected to affect future volatility. Once the news is priced into the stock, there is no point in hedgers’ buying options for protection or speculators’ buying options for aleveraged bet. What has happened has happened.
There are other conditions that can cause this type of pattern to materialize. In
Exhibit 14.3
, the IV was trading around 25 for several months, while the realized volatility was lagging. With hindsight, it makes perfect sense that something had to give—either IV needed to fall to meet realized, or realized would rise to meet market expectations. Here, indeed, the latter materialized as realized volatility had asteady rise to and through the 25 level in May. Implied, however remained constant.
EXHIBIT 14.3
Realized volatility rises, implied volatility remains constant.
Source
: Chart courtesy of
iVolatility.com
Traders who were long volatility going into the May realized-vol rise probably reaped some gamma benefits. But those who got in “too early,” buying in January or February, would have suffered too great of theta losses before gaining any significant profits from gamma. Time decay (theta) can inflict aslow, painful death on an option buyer. By studying this chart in hindsight, it is clear that options were priced too high for agamma scalper to have afighting chance of covering the daily theta before the rise in May.
This wasn’tnecessarily an easy vol-selling trade before the May realized-vol rise, either, depending on the trader’stiming. In early February, realized did in fact rise above implied, making the short volatility trade much less attractive.
Traders who sold volatility just before the increase in realized volatility in May likely ended up losing on gamma and not enough theta profits to make up for it. There was no volatility crush like what is often seen following aone-day move leading to sharply higher realized volatility. IV simply remained pretty steady throughout the month of May and well into June.
3. Realized Volatility Rises, Implied Volatility Falls
This chart pattern can manifest itself in different ways. In this scenario, the stock is becoming more volatile, and options are becoming cheaper. This may seem an unusual occurrence, but as we can see in
Exhibit 14.4
, volatility sometimes plays out this way. This chart shows two different examples of realized vol rising while IV falls.
EXHIBIT 14.4
Realized volatility rises, implied volatility falls.
Source
: Chart courtesy of
iVolatility.com
The first example, toward the left-hand side of the chart, shows realized volatility trending higher while IV is trending lower. Although fundamentals can often provide logical reasons for these volatility changes, sometimes they just can’t. Both i


y falls.
Source
: Chart courtesy of
iVolatility.com
The first example, toward the left-hand side of the chart, shows realized volatility trending higher while IV is trending lower. Although fundamentals can often provide logical reasons for these volatility changes, sometimes they just can’t. Both implied and realized volatility are ultimately afunction of the market. There is anormal oscillation to both of these figures. When there is no reason to be found for avolatility change, it might be an opportunity. The potential inefficiency of volatility pricing in the options market sometimes creates divergences such as this one that vol traders scour the market in search of.
In this first example, after at least three months of IV’strading marginally higher than realized volatility, the two lines converge and then cross. The point at which these lines meet is an indication that IV may be beginning to get cheap.
First, it’sapotentially beneficial opportunity to buy alower volatility than that at which the stock is actually moving. The gamma/theta ratio would be favorable to gamma scalpers in this case, because the lower cost of options compared with stock fluctuations could lead to gamma profits. Second, with IV at 35 at the first crossover on this chart, IV is dipping down into the lower part of its four-month range. One can make the case that it is getting cheaper from ahistorical IV standpoint. There is arguably an edge from the perspective of IV to realized volatility and IV to historical IV. This is an example of buying value in the context of volatility.
Furthermore, if the actual stock volatility is rising, it’sreasonable to believe that IV may rise, too. In hindsight we see that this did indeed occur in
Exhibit 14.4
, despite the fact that realized volatility declined.
The example circled on the right-hand side of the chart shows IV declining sharply while realized volatility rises sharply. This is an example of the typical volatility crush as aresult of an earnings report. This would probably have been agood trade for long volatility traders—even those buying at the top. Atrader buying options delta neutral the day before earnings are announced in this example would likely lose about 10 points of vega but would have agood chance to more than make up for that loss on positive gamma. Realized volatility nearly doubled, from around 28 percent to about 53 percent, in asingle day.
4. Realized Volatility Remains Constant, Implied Volatility Rises
Exhibit 14.5
shows that the stock is moving at about the same volatility from the beginning of June to the end of July. But during that time, option premiums are rising to higher levels. This is an atypical chart pattern. If this was aperiod leading up to an anticipated event, like earnings, one would anticipate realized volatility falling as the market entered await-and-see mode. But, instead, statistical volatility stays the same. This chart pattern may indicate apotential volatility-selling opportunity. If there is no news or reason for IV to have risen, it may simply be high tide in the normal ebb and flow of volatility.
EXHIBIT 14.5
Realized volatility remains constant, implied volatility rises.
Source
: Chart courtesy of
iVolatility.com
In this example, the historical volatility oscillates between 20 and 24 for nearly two months (the beginning of June through the end of July) as IV rises from 24 to over 30. The stock price is less volatile than option prices indicate. If there is no news to be dug up on the stock to lead one to believe there is avalid reason for the IV’strading at such alevel, this could be an opportunity to sell IV 5 to 10 points higher than the stock volatility. The goal here is to profit from theta or falling vega or both while not losing much on negative gamma. As time passes, if the stock continues to move at 20 to 23 vol, one would expect IV to fall and converge with realized volatility.
5. Realized Volatility Remains Constant, Implied Volatility Remains Constant
This volatility chart pattern shown in
Exhibit 14.6
is typical of aboring, run-of-the-mill stock with nothing happening in the news. But in this case, no news might be good news.
EXHIBIT 14.6
Realized volatility remains constant, implied volatility remains constant.
Source
: Chart courtesy of
iVolatility.com
Again, the gray is realized volatility and the black line is IV.
It’scommon for IV to trade slightly above or below realized volatility for extended periods of time in certain assets. In this example, the IV has traded in the high teens from late January to late July. During that same time, realized volatility has been in the low teens.
This is aprime environment for option sellers. From agamma/theta standpoint, the odds favor short-volatility traders. The gamma/theta ratio provides an edge, setting the stage for theta profits to outweigh negative-gamma scalping. Selling calls and buying stock delta neutral would be atrade to look at in this situation. But even more basic str

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. From agamma/theta standpoint, the odds favor short-volatility traders. The gamma/theta ratio provides an edge, setting the stage for theta profits to outweigh negative-gamma scalping. Selling calls and buying stock delta neutral would be atrade to look at in this situation. But even more basic strategies, such as time spreads and iron condors, are appropriate to consider.
This vol-chart pattern, however, is no guarantee of success. When the stock oscillates, delta-neutral traders can negative scalp stock if they are not careful by buying high to cover short deltas and then selling low to cover long deltas. Time-spread and iron condor trades can fail if volatility increases and the increase results from the stock trending in one direction. The advantage of buying IV lower than realized, or selling it above, is statistical in nature. Traders should use achart of the stock price in conjunction with the volatility chart to get amore complete picture of the stock’sprice action. This also helps traders make more informed decisions about when to hedge.
6. Realized Volatility Remains Constant, Implied Volatility Falls
Exhibit 14.7
shows two classic implied-realized convergences. From mid-September to early November, realized volatility stayed between 22 and 25. In mid-October the implied was around 33. Within the span of afew days, the implied vol collapsed to converge with the realized at about 22.
EXHIBIT 14.7
Realized volatility remains constant, implied volatility falls.
Source
: Chart courtesy of
iVolatility.com
There can be many catalysts for such adrop in IV, but there is truly only one reason: arbitrage. Although it is common for asmall difference between implied and realized volatility—1 to 3 points—to exist even for extended periods, bigger disparities, like the 7- to 10-point difference here cannot exist for that long without good reason.
If, for example, IV always trades significantly above the realized volatility of aparticular underlying, all rational market participants will sell options because they have agamma/theta edge. This, in turn, forces options prices lower until volatility prices come into line and the arbitrage opportunity no longer exists.
In
Exhibit 14.7
, from mid-March to mid-May asimilar convergence took place but over alonger period of time. These situations are often the result of aslow capitulation of market makers who are long volatility. The traders give up on the idea that they will be able to scalp enough gamma to cover theta and consequently lower their offers to advertise their lower prices.
7. Realized Volatility Falls, Implied Volatility Rises
This setup shown in
Exhibit 14.8
should now be etched into the souls of anyone who has been reading up to this point. It is, of course, the picture of the classic IV rush that is often seen in stocks around earnings time. The more uncertain the earnings, the more pronounced this divergence can be.
EXHIBIT 14.8
Realized volatility falls, implied volatility rises.
Source
: Chart courtesy of
iVolatility.com
Another classic vol divergence in which IV rises and realized vol falls occurs in adrug or biotech company when a Food and Drug Administration (FDA) decision on one of the company’snew drugs is imminent. This is especially true of smaller firms without big portfolios of drugs. These divergences can produce ahuge implied–realized disparity of, in some cases, literally hundreds of volatility points leading up to the announcement.
Although rising IV accompanied by falling realized volatility can be one of the most predictable patterns in trading, it is ironically one of the most difficult to trade. When the anticipated news breaks, the stock can and often will make abig directional move, and in that case, IV can and likely will get crushed. Vega and gamma work against each other in these situations, as IV and realized volatility converge. Vol traders will likely gain on one vol and lose on the other, but it’svery difficult to predict which will have amore profound effect. Many traders simply avoid trading earnings events altogether in favor of less erratic opportunities. For most traders, there are easier ways to make money.
8. Realized Volatility Falls, Implied Volatility Remains Constant
This volatility shift can be marked by avolatility convergence, divergence, or crossover.
Exhibit 14.9
shows the realized volatility falling from around 30 percent to about 23 percent while IV hovers around 25. The crossover here occurs around the middle of February.
EXHIBIT 14.9
Realized volatility falls, implied volatility remains constant.
Source
: Chart courtesy of
iVolatility.com
The relative size of this volatility change makes the interpretation of the chart difficult. The last half of September saw around a 15 percent decline in realized volatility. The middle of October saw aone-day jump in realized of about 15 points. Historical volatility has had several dynamic moves that were larger and more abrupt than the seven-point decline over this


the chart difficult. The last half of September saw around a 15 percent decline in realized volatility. The middle of October saw aone-day jump in realized of about 15 points. Historical volatility has had several dynamic moves that were larger and more abrupt than the seven-point decline over this six-week period. This smaller move in realized volatility is not necessarily an indication of avolatility event. It could reflect some complacency in the market. It could indicate aslow period with less trading, or it could simply be anatural contraction in the ebb and flow of volatility causing the calculation of recent stock-price fluctuations to wane.
What is important in this interpretation is how the options market is reacting to the change in the volatility of the stock—where the rubber hits the road. The market’sapparent assessment of future volatility is unchanged during this period. When IV rises or falls, vol traders must look to the underlying stock for areason. The options market reacts to stock volatility, not the other way around.
Finding fundamental or technical reasons for surges in volatility is easier than finding specific reasons for adecline in volatility. When volatility falls, it is usually the result of alack of news, leading to less price action. In this example, probably nothing happened in the market. Consequently, the stock volatility drifted lower. But it fell below the lowest IV level seen for the six-month period leading up to the crossover. It was probably hard to take aconfident stance in volatility immediately following the crossover. It is difficult to justify selling volatility when the implied is so cheap compared with its historic levels. And it can be hard to justify buying volatility when the options are priced above the stock volatility.
The two-week period before the realized line moved beneath the implied line deserves closer study. With the IV four or five points lower than the realized volatility in late January, traders may have been tempted to buy volatility. In hindsight, this trade might have been profitable, but there was surely no guarantee of this. Success would have been greatly contingent on how the traders managed their deltas, and how well they adapted as realized volatility fell.
During the first half of this period, the stock volatility remained above implied. For an experienced delta-neutral trader, scalping gamma was likely easy money. With the oscillations in stock price, the biggest gamma-scalping risk would have been to cover too soon and miss out on opportunities to take bigger profits.
Using the one-day standard deviation based on IV (described in Chapter 3) might have produced early covering for long-gamma traders. Why? Because in late January, the standard deviation derived from IV was lower than the actual standard deviation of the stock being traded. In the latter half of the period being studied, the end of February on this chart, using the one-day standard deviation based on IV would have produced scalping that was too late. This would have led to many missed opportunities.
Traders entering hedges at regular nominal intervals—every $0.50, for example—would probably have needed to decrease the interval as volatility ebbed. For instance, if in late January they were entering orders every $0.50, by late February they might have had to trade every $0.40.
9. Realized Volatility Falls, Implied Volatility Falls
This final volatility-chart permutation incorporates afall of both realized and IV. The chart in
Exhibit 14.10
clearly represents the slow culmination of ahighly volatile period. This setup often coincides with news of some scary event’sbeing resolved—alaw suit settled, unpopular upper management leaving, rumors found to be false, ahappy ending to political issues domestically or abroad, for example. After asharp sell-off in IV, from 75 to 55, in late October, marking the end of aperiod of great uncertainty, the stock volatility began asteady decline, from the low 50s to below 25. IV fell as well, although it remained abit higher for several months.
EXHIBIT 14.10
Realized volatility falls, implied volatility falls.
Source
: Chart courtesy of
iVolatility.com
In some situations where an extended period of extreme volatility appears to be coming to an end, there can be some predictability in how IV will react. To be sure, no one knows what the future holds, but when volatility starts to wane because aspecific issue that was causing gyrations in the stock price is resolved, it is common, and intuitive, for IV to fall with the stock volatility. This is another type of example of reversion to the mean.
There is apotential problem if the high-volatility period lasted for an extended period of time. Sometimes, it’shard to get afeel for what the mean volatility should be. Or sometimes, because of the event, the stock is fundamentally different—in the case of aspin-off, merger, or other corporate action, for example. When it is difficult or impossible to


iod lasted for an extended period of time. Sometimes, it’shard to get afeel for what the mean volatility should be. Or sometimes, because of the event, the stock is fundamentally different—in the case of aspin-off, merger, or other corporate action, for example. When it is difficult or impossible to look back at astock’sperformance over the previous 6 to 12 months and appraise what the normal volatility should be, one can look to the volatility of other stocks in the same industry for some guidance.
Stocks that are substitutable for one another typically trade at similar volatilities. From arealized volatility perspective, this is rather intuitive. When one stock within an industry rises or falls, others within the same industry tend to follow. They trade similarly and therefore experience similar volatility patterns. If the stock volatility among names within one industry tends to be similar, it follows that the IV should be, too.
Regardless which of the nine patterns discussed here show up, or how the volatilities line up, there is one overriding observation that’srepresentative of all volatility charts: vol charts are simply graphical representations of realized and implied volatility that help traders better understand the two volatilities’ interaction. But the divergences and convergences in the examples in this chapter have profound meaning to the volatility trader. Combined with acomparison of current and past volatility (both realized and implied), they give traders insight into how cheap or expensive options are.
Note
1
. The following examples use charts supplied by
iVolatility.com
. The gray line is the 30-day realized volatility, and the black line is the implied volatility.


CHAPTER 15
Straddles and Strangles
Straddles and strangles are the quintessential volatility strategies. They are the purest ways to buy and sell realized and implied volatility. This chapter discusses straddles and strangles, how they work, when to use them, what to look out for, and the differences between the two.
Long Straddle
Definition
: Buying one call and one put in the same option class, in the same expiration cycle, and with the same strike price.
Linearly, the long straddle is the best of both worlds—long acall and aput. If the stock rises, the call enjoys the unlimited potential for profit while the put’slosses are decidedly limited. If the stock falls, the put’sprofit potential is bound only by the stock’sfalling to zero, while the call’spotential loss is finite. Directionally, this can be awin-win situation—as long as the stock moves enough for one option’sprofit to cover the loss on the other. The risk, however, is that this may not happen. Holding two long options means abig penalty can be paid for stagnant stocks.
The Basic Long Straddle
The long straddle is an option strategy to use when atrader is looking for abig move in astock but is uncertain which direction it will move. Technically, the Commodity Channel Index (CCI), Bollinger bands, or pennants are some examples of indicators which might signal the possibility of abreakout. Or fundamental data might call for arevaluation of the stock based on an impending catalyst. In either case, along straddle, is away for traders to position themselves for the expected move, without regard to direction. In this example, we’ll study ahypothetical $70 stock poised for abreakout. We’ll buy the one-month 70 straddle for 4.25.
Exhibit 15.1
shows the payout of the straddle at expiration.
EXHIBIT 15.1
At-expiration diagram for along straddle.
At expiration, with the stock at $70, neither the call nor the put is in-the-money. The straddle expires worthless, leaving aloss of 4.25 in its wake from erosion. If, however, the stock is above or below $70, either the call or the put will have at least some value. The farther the stock price moves from the strike price in either direction, the higher the net value of the options.
Above $70, the call has value. If the underlying is at $74.25 at expiration, the put will expire worthless, but the call will be worth 4.25—the price initially paid for the straddle. Above this break-even price, the trade is awinner, and the higher, the better. Below $70, the put has value. If the underlying is at $65.75 at expiration, the call expires, and the put is worth 4.25. Below this breakeven, the straddle is awinner, and the lower, the better.
Why It Works
In this basic example, if the underlying is beyond either of the break-even points at expiration, the trade is awinner. The key to understanding this is the fact that at expiration, the loss on one option is limited—it can only fall to zero—but the profit potential on the other can be unlimited.
In practice, most active traders will not hold astraddle until expiration. Even if the trade is not held to term, however, movement is still beneficial—in fact, it is more beneficial, because time decay will not have depleted all the extrinsic value of the options. Movement benefits the long straddle because of positive gamma. But movement is arace against the clock—arace against theta. Theta is the cost of trading the long straddle. Only pay it for as long as necessary. When the stock’svolatility appears poised to ebb, exit the trade.
Exhibit 15.2
shows the P&(L) of the straddle both at expiration and at the time the trade was made.
EXHIBIT 15.2
Long straddle P&(L) at initiation and expiration.
Because this is ashort-term at-the-money (ATM) straddle, we will assume for simplicity that it has adelta of zero.
1
When the trade is consummated, movement can only help, as indicated by the dotted line on the exhibit. This is the classic graphic representation of positive gamma—the smiley face. When the stock moves higher, the call gains value at an increasing rate while the put loses value at adecreasing rate. When the stock moves lower, the put gains at an increasing rate while the call loses at adecreasing rate. This is positive gamma.
This still may not be an entirely fair representation of how profits are earned. The underlying is not required to move continuously in one direction for traders to reap gamma profits. As described in Chapter 13, traders can scalp gamma by buying and selling stock to offset long or short deltas created by movement in the underlying. When traders scalp gamma, they lock in profits as the stock price oscillates.
The potential for gamma scalping is an important motivation for straddle buyers. Gamma scalping astraddle gives traders the chance to profit from astock that has dynamic price swings. It should be second nature to volatility traders to understand that theta is the trade-off of gamma scalping.
The Big V
Gamma and theta are not alone in the straddle buye

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ation for straddle buyers. Gamma scalping astraddle gives traders the chance to profit from astock that has dynamic price swings. It should be second nature to volatility traders to understand that theta is the trade-off of gamma scalping.
The Big V
Gamma and theta are not alone in the straddle buyer’sthoughts. Vega is amajor consideration for astraddle buyer, as well. In astraddle, there are two long options of the same strike, which means double the vega risk of asingle-leg trade at that strike. With no short options in this spread, the implied-volatility exposure is concentrated. For example, if the call has avega of 0.05, the put’svega at that same strike will also be about 0.05. This means that buying one straddle gives the trader exposure of around 10 cents per implied volatility (IV) point. If IV rises by one point, the trader makes $10 per one-lot straddle, $20 for two points, and so on. If IV falls one point, the trader loses $10 per straddle, $20 for two points, and so on. Traders who want maximum positive exposure to volatility find it in long straddles.
This strategy is aprime example of the marriage of implied and realized volatility. Traders who buy straddles because they are bullish on realized volatility will also have bullish positions in implied volatility—like it or not. With this in mind, traders must take care to buy gamma via astraddle that it is not too expensive in terms of the implied volatility. Awinning gamma trade can quickly become aloser because of implied volatility. Likewise, traders buying straddles to speculate on an increase in implied volatility must take the theta risk of the trade very seriously. Time can eat away all atrade’svega profits and more. Realized and implied exposure go hand in hand.
The relationship between gamma and vega depends on, among other things, the time to expiration. Traders have some control over the amount of gamma relative to the amount of vega by choosing which expiration month to trade. The shorter the time until expiration, the higher the gammas and the lower the vegas of ATM options. Gamma traders may be better served by buying short-term contracts that coincide with the period of perceived high stock volatility.
If the intent of the straddle is to profit from vega, the choice of the month to trade depends on which month’svolatility is perceived to be too high or too low. If, for example, the front-month IV looks low compared with historical IV, current and historical realized volatility, and the expected future volatility, but the back months’ IVs are higher and more in line with these other metrics, there would be no point in buying the back-month options. In this case, traders would need to buy the month that they think is cheap.
Trading the Long Straddle
Option trading is all about optimizing the statistical chances of success. Along-straddle trade makes the most sense if traders think they can make money on both implied volatility and gamma. Many traders make the mistake of buying astraddle just before earnings are announced because they anticipate abig move in the stock. Of course, stock-price action is only half the story. The option premium can be extraordinarily expensive just before earnings, because the stock move is priced into the options. This is buying after the rush and before the crush. Although some traders are successful specializing in trading earnings, this is ahard way to make money.
Ideally, the best time to buy volatility is before the move is priced in—that is, before everyone else does. This is conceptually the same as buying astock in anticipation of bullish news. Once news comes out, the stock rallies, and it is often too late to participate in profits. The goal is to get in at the beginning of the trend, not the end—the same goal as in trading volatility.
As in analyzing astock, fundamental and technical tools exist for analyzing volatility—namely, news and volatility charts. For fundamentals, buy the rumor, sell the news applies to the rush and crush of implied volatility. Previous chapters discussed fundamental events that affect volatility; be prepared to act fast when volatility-changing situations present themselves. With charts, the elementary concept of buy low, sell high is obvious, yet profound. Review Chapter 14 for guidance on reading volatility charts.
With all trading, getting in is easy. It’smanaging the position, deciding when to hedge and when to get out that is the tricky part. This is especially true with the long straddle. Straddles are intended to be actively managed. Instead of waiting for abig linear move to evolve over time, traders can take profits intermittently through gamma scalping. Furthermore, they hold the trade only as long as gamma scalping appears to be apromising opportunity.
Legging Out
There are many ways to exiting astraddle. In the right circumstances, legging out is the preferred method. Instead of buying and selling stock to lock in profits and maintain delta neutrality, t


ore, they hold the trade only as long as gamma scalping appears to be apromising opportunity.
Legging Out
There are many ways to exiting astraddle. In the right circumstances, legging out is the preferred method. Instead of buying and selling stock to lock in profits and maintain delta neutrality, traders can reduce their positions by selling off some of the calls or puts that are part of the straddle. In this technique, when the underlying rises, traders sell as many calls as needed to reduce the delta to zero. As the underlying falls, they sell enough puts to reduce their position to zero delta. As the stock oscillates, they whittle away at the position with each hedging transaction. This serves the dual purpose of taking profits and reducing risk.
Atrader, Susan, has been studying Acme Brokerage Co. (ABC). Susan has noticed that brokerage stocks have been fairly volatile in recent past.
Exhibit 15.3
shows an analysis of Acme’svolatility over the past 30 days.
EXHIBIT 15.3
Acme Brokerage Co. volatility.
Stock Price
Realized Volatility
Front-Month Implied Volatility
30-day high $78.66
30-day high 47%
30-day high 55%
30-day low $66.94
30-day low 36%
30-day low 34%
Current px $74.80
Current vol 36%
Current vol 36%
During this period, Acme stock ranged more than $11 in price. In this example, Acme’svolatility is afunction of interest rate concerns and other macroeconomic issues affecting the brokerage industry as awhole. As the stock price begins to level off in the latter half of the 30-day period, realized volatility begins to ebb. The front month’s IV recedes toward recent lows as well. At this point, both realized and implied volatility converge at 36 percent. Although volatility is at its low for the past month, it is still relatively high for abrokerage stock under normal market conditions.
Susan does not believe that the volatility plaguing this stock is over. She believes that an upcoming scheduled Federal Reserve Board announcement will lead to more volatility. She perceives this to be avolatility-buying opportunity. Effectively, she wants to buy volatility on the dip. Susan pays 5.75 for 20 July 75-strike straddles.
Exhibit 15.4
shows the analytics of this trade with four weeks until expiration.
EXHIBIT 15.4
Analytics for long 20 Acme Brokerage Co. 75-strike straddles.
As with any trade, the risk is that the trader is wrong. The risk here is indicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an average of at least $207 aday just to break even against the time decay. And if IV continues to ebb down to alower, more historically normal, level, she needs to scalp even more to make up for vega losses.
Effectively, Susan wants both realized and implied volatility to rise. She paid 36 volatility for the straddle. She wants to be able to sell the options at ahigher vol than 36. In the interim, she needs to cover her decay just to break even. But in this case, she thinks the stock will be volatile enough to cover decay and then some. If Acme moves at avolatility greater than 36, her chances of scalping profitably are more favorable than if it moves at less than 36 vol. The following is one possible scenario of what might have happened over two weeks after the trade was made.
Week One
During the first week, the stock’svolatility tapered off abit more, but implied volatility stayed firm. After some oscillation, the realized volatility ended the week at 34 percent while IV remained at 36 percent. Susan was able to scalp stock reasonably well, although she still didn’tcover her seven days of theta. Her stock buys and sells netted again of $1,100. By the end of week one, the straddle was 5.10 bid. If she had sold the straddle at the market, she would have ended up losing $200.
Susan decided to hold her position. Toward the end of week two, there would be the Federal Open Market Committee (FOMC) meeting.
Week Two
The beginning of the week saw IV rise as the event drew near. By the close on Tuesday, implied volatility for the straddle was 40 percent. But realized volatility continued its decline, which meant Susan was not able to scalp to cover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle was now 5.20 bid, 0.10 higher than it had been on previous Friday. The rising IV made up for most of the theta loss. At this point, Susan could have sold her straddle to scratch her trade. She would have lost $1,100 on the straddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the first week. Susan decided to wait and see what the Fed chairman had to say.
By week’send, the trade had proved to be profitable. After the FOMC meeting, the stock shot up more than $4 and just as quickly fell. It continued to bounce around abit for the rest of the week. Susan was able to lock in $5,200 from stock scalps. After much gyration over this two-week period, the price of Acme stock incidentally returned to around the same price it had been at when Susan bought her straddle: $74.50. As might h


ll. It continued to bounce around abit for the rest of the week. Susan was able to lock in $5,200 from stock scalps. After much gyration over this two-week period, the price of Acme stock incidentally returned to around the same price it had been at when Susan bought her straddle: $74.50. As might have been expected after the announcement, implied volatility softened. By Friday, IV had fallen to 30. Realized volatility was sharply higher as aresult of the big moves during the week that were factored into the 30-day calculation.
With seven more days of decay and alower implied volatility, the straddle was 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the position. Her profit for week two was $2,000.
What went into Susan’sdecision to close her position? Susan had two objectives: to profit from arise in implied volatility and to profit from arise in realized volatility. The rise in IV did indeed occur, but not immediately. By Tuesday of the second week, vega profits were overshadowed by theta losses.
Gamma was the saving grace with this trade. The bulk of the gain occurred in week two when the Fed announcement was made. Once that event passed, the prospects for covering theta looked less attractive. They were further dimmed by the sharp drop in implied volatility from 40 to 30.
In this hypothetical scenario, the trade ended up profitable. This is not always the case. Here the profit was chiefly produced by one or two high-volatility days. Had the stock not been unusually volatile during this time, the trade would have been acertain loser. Even though implied volatility had risen four points by Tuesday of the second week, the trade did not yield aprofit. The time decay of holding two options can make long straddles atough strategy to trade.
Short Straddle
Definition
: Selling one call and one put in the same option class, in the same expiration cycle, and with the same strike price.
Just as buying astraddle is apure way to buy volatility, selling astraddle is away to short it. When atrader’sforecast calls for lower implied and realized volatility, astraddle generates the highest returns of all volatility-selling strategies. Of course, with high reward necessarily comes high risk. Ashort straddle is one of the riskiest positions to trade.
Let’slook at aone-month 70-strike straddle sold at 4.25.
The risk is easily represented graphically by means of a P&(L) diagram.
Exhibit 15.5
shows the risk and reward of this short straddle.
EXHIBIT 15.5
Short straddle P&(L) at initiation and expiration.
If the straddle is held until expiration and the underlying is trading below the strike price, the short put is in-the-money (ITM). The lower the stock, the greater the loss on the +1.00 delta from the put. The trade as awhole will be aloser if the underlying is below the lower of the two break-even points—in this case $65.75. This point is found by subtracting the premium received from the strike. Before expiration, negative gamma adversely affects profits as the underlying falls. The lower the underlying is trading below the strike price, the greater the drain on P&(L) due to the positive delta of the short put.
It is the same proposition if the underlying is above $70 at expiration. But in this case, it is the short call that would be in-the-money. The higher the underlying price, the more the −1.00 delta adversely impacts P&(L). If at expiration the underlying is above the higher breakeven, which in this case is $74.25 (the strike plus the premium), the trade is aloser. The higher the underlying, the worse off the trade. Before expiration, negative gamma creates negative deltas as the underlying climbs above the strike, eating away at the potential profit, which is the net premium received.
The best-case scenario is that the underlying is right at $70 at the closing bell on expiration Friday. In this situation, neither option is ITM, meaning that the 4.25 premium is all profit. In reaping the maximum profit, both time and price play roles. If the position is closed before expiration, implied volatility enters into the picture as well.
It’simportant to note that just because neither option is ITM if the underlying is right at $70 at expiration, it doesn’tmean with certainty that neither option will be assigned. Sometimes options that are ATM or even out-of-the-money (OTM) get assigned. This can lead to apleasant or unpleasant surprise the Monday morning following expiration. The risk of not knowing whether or not you will be assigned—that is, whether or not you have aposition in the underlying security—is arisk to be avoided. It is the goal of every trader to remove unnecessary risk from the equation. Buying the call and the put for 0.05 or 0.10 to close the position is asmall price to pay when one considers the possibility of waking up Monday morning to find aloss of hundreds of dollars per contract because aposition you didn’teven know you owned had moved against you. Most traders avoid this risk, ref


the call and the put for 0.05 or 0.10 to close the position is asmall price to pay when one considers the possibility of waking up Monday morning to find aloss of hundreds of dollars per contract because aposition you didn’teven know you owned had moved against you. Most traders avoid this risk, referred to as pin risk, by closing short options before expiration.
The Risks with Short Straddles
Looking at an at-expiration diagram or even analyzing the gamma/theta relationship of ashort straddle may sometimes lead to afalse sense of comfort. Sometimes it looks as if short straddles need apretty big move to lose alot of money. So why are they definitely among the riskiest strategies to trade? That is amatter of perspective.
Option trading is about risk management. Dealing with aproverbial train wreck every once in awhile is part of the game. But the big disasters can end one’strading career in an instant. Because of its potential—albeit sometimes small potential—for acolossal blowup, the short straddle is, indeed, one of the riskiest positions one can trade. That said, it has aplace in the arsenal of option strategies for speculative traders.
Trading the Short Straddle
Ashort straddle is atrade for highly speculative traders who think asecurity will trade within adefined range and that implied volatility is too high. While along straddle needs to be actively traded, ashort straddle needs to be actively monitored to guard against negative gamma. As adverse deltas get bigger because of stock price movement, traders have to be on alert, ready to neutralize directional risk by offsetting the delta with stock or by legging out of the options. To be sure, with ashort straddle, every stock trade locks in aloss with the intent of stemming future losses. The ideal situation is that the straddle is held until expiration and expires with the underlying right at $70 with no negative-gamma scalping.
Short-straddle traders must take alonger-term view of their positions than long-straddle traders. Often with short straddles, it is ultimately time that provides the payout. While long straddle traders would be inclined to watch gamma and theta very closely to see how much movement is required to cover each day’serosion, short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game.
There are some situations that are exceptions to this long-term focus. For example, when implied volatility gets to be extremely high for aparticular option class relative to both the underlying stock’svolatility and the historical implied volatility, one may want to sell astraddle to profit from afall in IV. This can lead to leveraged short-term profits if implied volatility does, indeed, decline.
Because of the fact that there are two short options involved, these straddles administer aconcentrated dose of negative vega. For those willing to bet big on adecline in implied volatility, ashort straddle is an eager croupier. These trades are delta neutral and double the vega of asingle-leg trade. But they’re double the gamma, too. As with the long straddle, realized and implied volatility levels are both important to watch.
Short-Straddle Example
For this example, atrader, John, has been watching Federal XYZ Corp. (XYZ) for ayear. During the 12 months that John has followed XYZ, its front-month implied volatility has typically traded at around 20 percent, and its realized volatility has fluctuated between 15 and 20 percent. The past 30 days, however, have been abit more volatile.
Exhibit 15.6
shows XYZ’srecent volatility.
EXHIBIT 15.6
XYZ volatility.
Stock Price
Realized Volatility
Front-Month Implied Volatility
30-day high $111.71
30-day high 26%
30-day high 30%
30-day low $102.05
30-day low 21%
30-day low 24%
Current px $104.75
Current vol 22%
Current vol 26%
The stock volatility has begun to ease, trading now at a 22 volatility compared with the 30-day high of 26, but still not down to the usual 15-to-20 range. The stock, in this scenario, has traded in achannel. It currently lies in the lower half of its recent range. Although the current front-month implied volatility is in the lower half of its 30-day range, it’shistorically high compared with the 20 percent level that John has been used to seeing, and it’sstill four points above the realized volatility. John believes that the conditions that led to the recent surge in volatility are no longer present. His forecast is for the stock volatility to continue to ease and for implied volatility to continue its downtrend as well and revert to its long-term mean over the next week or two. John sells 10 September 105 straddles at 5.40.
Exhibit 15.7
shows the greeks for this trade.
EXHIBIT 15.7
Greeks for short XYZ straddle.
The goal here is for implied volatility to fall to around 20. If it does, John makes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will outpace gamma losses. The following is atwo-week examination of one possible outco


reeks for this trade.
EXHIBIT 15.7
Greeks for short XYZ straddle.
The goal here is for implied volatility to fall to around 20. If it does, John makes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will outpace gamma losses. The following is atwo-week examination of one possible outcome for John’strade.
Week One
The first week in this example was aprofitable one, but it came with challenges. John paid for his winnings with afew sleepless nights. On the Monday following his entry into the trade, the stock rose to $106. While John collected aweekend’sworth of time decay, the $1.25 jump in stock price ate into some of those profits and naturally made him uneasy about the future.
At this point, John was sitting on aprofit, but his position delta began to grow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75 stock, amove of $1.25—or just over 1 percent—is not out of the ordinary, but it put John on his guard. He decided to wait and see what happened before hedging.
The following day, the rally continued. The stock was at $107.30 by noon. His delta was around −3. In the face of an increasingly negative delta, John weighed his alternatives: He could buy back some of his calls to offset his delta, which would have the added benefit of reducing his gamma as well. He could buy stock to flatten out. Lastly, he could simply do nothing and wait. John felt the stock was overbought and might retrace. He also still believed volatility would fall. He decided to be patient and enter astop order to buy all of his deltas at $107.50 in case the stock continued trending up. The XYZ shares closed at $107.45 that day.
This time inaction proved to be the best action. The stock did retrace. Week one ended with Federal XYZ back down around $105.50. The IV of the straddle was at 23. The straddle finished up week one offered at $4.10.
Week Two
The future was looking bright at the start of week two until Wednesday. Wednesday morning saw XYZ gap open to $109. When you have ashort straddle, a $3.50 gap move in the underlying tends to instantly give you asinking feeling in the pit of your stomach. But the damage was truly not that bad. The offer in the straddle was 4.75, so the position was still awinner if John bought it back at this point.
Gamma/delta hurt. Theta helped. Acharacteristic that enters into this trade is volatility’schanging as aresult of movement in the stock price. Despite the fact that the stock gapped $3.50 higher, implied volatility fell by 1 percent, to 22. This volatility reaction to the underlying’srise in price is very common in many equity and index options. John decided to close the trade. Nobody ever went broke taking aprofit.
The trade in this example was profitable. Of course, this will not always be the case. Sometimes short straddles will be losers—sometimes big ones. Big moves and rising implied volatility can be perilous to short straddles and their writers. If the XYZ stock in the previous example had gapped up to $115—which is not an unreasonable possibility—John’strade would have been ugly.
Synthetic Straddles
Straddles are the pet strategy of certain professional traders who specialize in trading volatility. In fact, in the mind of many of these traders, astraddle is all there is. Any single-legged trade can be turned into astraddle synthetically simply by adding stock.
Chapter 6 discussed put-call parity and showed that, for all intents and purposes, aput is acall and acall is aput. For the most part, the greeks of the options in the put-call pair are essentially the same. The delta is the only real difference. And, of course, that can be easily corrected. As amatter of perspective, one can make the case that buying two calls is essentially the same as buying acall and aput, once stock enters into the equation.
Take anon-dividend-paying stock trading at $40 ashare. With 60 days until expiration, a 25 volatility, and a 4 percent interest rate, the greeks of the 40-strike calls and puts of the straddle are as follows:
Essentially, the same position can be created by buying one leg of the spread synthetically. For example, in addition to buying one 40 call, another 40 call can be purchased along with shorting 100 shares of stock to create a 40 put synthetically.
Combined, the long call and the synthetic long put (long call plus short stock) creates asynthetic straddle. Along synthetic straddle could have similarly been constructed with along put and along synthetic call (long put plus long stock). Furthermore, ashort synthetic straddle could be created by selling an option with its synthetic pair.
Notice the similarities between the greeks of the two positions. The synthetic straddle functions about the same as aconventional straddle. Because the delta and gamma are nearly the same, the up-and-down risk is nearly the same. Time and volatility likewise affect the two trades about the same. The only real difference is that the synthetic straddle might require abit more cash up


dle functions about the same as aconventional straddle. Because the delta and gamma are nearly the same, the up-and-down risk is nearly the same. Time and volatility likewise affect the two trades about the same. The only real difference is that the synthetic straddle might require abit more cash up front, because it requires buying or shorting the stock. In practice, straddles will typically be traded in accounts with retail portfolio margining or professional margin requirements (which can be similar to retail portfolio margining). So the cost of the long stock or margin for short stock is comparatively small.
Long Strangle
Definition
: Buying one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typical long strangles involve an OTM call and an OTM put. Astrangle in which an ITM call and an ITM put are purchased is called along guts strangle.
Along strangle is similar to along straddle in many ways. They both require buying acall and aput on the same class in the same expiration month. They are both buying volatility. There are, however, some functional differences. These differences stem from the fact that the options have different strike prices.
Because there is distance between the strike prices, from an at-expiration perspective, the underlying must move more for the trade to show aprofit.
Exhibit 15.8
illustrates the payout of options as part of along strangle on a $70 stock. The graph is much like that of
Exhibit 15.1
, which shows the payout of along straddle. But the net cost here is only 1.00, compared with 4.25 for the straddle with the same time and volatility inputs. The cost is lower because this trade consists of OTM options instead of ATM options. The breakdown is as follows:
EXHIBIT 15.8
Long strangle at-expiration diagram.
The underlying has abit farther to go by expiration for the trade to have value. If the underlying is above $75 at expiration, the call is ITM and has value. If the underlying is below $65 at expiration, the put is ITM and has value. If the underlying is between the two strike prices at expiration both options expire and the 1.00 premium is lost.
An important difference between astraddle and astrangle is that if astrangle is held until expiration, its break-even points are farther apart than those of acomparable straddle. The 70-strike straddle in
Exhibit 15.1
had alower breakeven of $65.75 and an upper break-even of $74.25. The comparable strangle in this example has break-even prices of $64 and $76.
But what if the strangle is not held until expiration? Then the trade’sgreeks must be analyzed. Intuitively, two OTM options (or ITM ones, for that matter) will have lower gamma, theta, and vega than two comparable ATM options. This has atwo-handed implication when comparing straddles and strangles.
On the one hand, from arealized volatility perspective, lower gamma means the underlying must move more than it would have to for astraddle to produce the same dollar gain per spread, even intraday. But on the other hand, lower theta means the underlying doesn’thave to move as much to cover decay. Alower nominal profit but ahigher percentage profit is generally reaped by strangles as compared with straddles.
Along strangle composed of two OTM options will also give positive exposure to implied volatility but, again, not as much as an ATM straddle would. Positive vega really kicks in when the underlying is close to one of the strike prices. This is important when anticipating changes in the stock price and in IV.
Say atrader expects implied volatility to rise as aresult of higher stock volatility. As the stock rises or falls, the strangle will move toward the price point that offers the highest vega (the strike). With astraddle, the stock will be moving away from the point with the highest vega. If the stock doesn’tmove as anticipated, the lower theta and vega of the strangle compared with the ATM straddle have aless adverse effect on P&L.
Long-Strangle Example
Let’sreturn to Susan, who earlier in this chapter bought astraddle on Acme Brokerage Co. (ABC). Acme currently trades at $74.80 ashare with current realized volatility at 36 percent. The stock’svolatility range for the past month was between 36 and 47. The implied volatility of the four-week options is 36 percent. The range over the past month for the IV of the front month has been between 34 and 55.
As in the long-straddle example earlier in this chapter, there is agreat deal of uncertainty in brokerage stocks revolving around interest rates, credit-default problems, and other economic issues. An FOMC meeting is expected in about one week’stime about whose possible actions analysts’ estimates vary greatly, from acut of 50 basis points to no cut at all. Add apending earnings release to the docket, and Susan thinks Acme may move quite abit.
In this case, however, instead of buying the 75-strike straddle, Susan pays 2.35 for 20 one-month 70–80 strangles.
Exhibit 15.


ions analysts’ estimates vary greatly, from acut of 50 basis points to no cut at all. Add apending earnings release to the docket, and Susan thinks Acme may move quite abit.
In this case, however, instead of buying the 75-strike straddle, Susan pays 2.35 for 20 one-month 70–80 strangles.
Exhibit 15.9
compares the greeks of the long ATM straddle with those of the long strangle.
EXHIBIT 15.9
Long straddle versus long strangle.
The cost of the strangle, at 2.35, is about 40 percent of the cost of the straddle. Of course, with two long options in each trade, both have positive gamma and vega and negative theta, but the exposure to each metric is less with the strangle. Assuming the same stock-price action, astrangle would enjoy profits from movement and losses from lack of movement that were similar to those of astraddle—just nominally less extreme.
For example, if Acme stock rallies $5, from $74.80 to $79.80, the gamma of the 75 straddle will grow the delta favorably, generating again of 1.50, or about 25 percent. The 70–80 strangle will make 1.15 from the curvature of the delta–almost a 50 percent gain.
With the straddle and especially the strangle, there is one more detail to factor in when considering potential P&L: IV changes due to stock price movement. IV is likely to fall as the stock rallies and rise as the stock declines. The profits of both the long straddle and the long strangle would likely be adversely affected by IV changes as the stock rose toward $79.80. And because the stock would be moving away from the straddle strike and toward one of the strangle strikes, the vegas would tend to become more similar for the two trades. The straddle in this example would have avega of 2.66, while the strangle’svega would be 2.67 with the underlying at $79.80 per share.
Short Strangle
Definition
: Selling one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typically, an OTM call and an OTM put are sold. Astrangle in which an ITM call and an ITM put are sold is called ashort guts strangle.
Ashort strangle is avolatility-selling strategy, like the short straddle. But with the short strangle, the strikes are farther apart, leaving more room for error. With these types of strategies, movement is the enemy. Wiggle room is the important difference between the short-strangle and short-straddle strategies. Of course, the trade-off for ahigher chance of success is lower option premium.
Exhibit 15.10
shows the at-expiration diagram of ashort strangle sold at 1.00, using the same options as in the diagram for the long strangle.
EXHIBIT 15.10
Short strangle at-expiration diagram.
Note that if the underlying is between the two strike prices, the maximum gain of 1.00 is harvested. With the stock below $65 at expiration, the short put is ITM, with a +1.00 delta. If the stock price is below the lower breakeven of $64 (the put strike minus the premium), the trade is aloser. The lower the stock, the bigger the loss. If the underlying is above $75, the short call is ITM, with a −1.00 delta. If the stock is above the upper breakeven of $76 (the call strike plus the premium), the trade is aloser. The higher the stock, the bigger the loss.
Intuitively, the signs of the greeks of this strangle should be similar to those of ashort straddle—negative gamma and vega, positive theta. That means that increased realized volatility hurts. Rising IV hurts. And time heals all wounds—unless, of course, the wounds caused by gamma are greater than the net premium received.
This brings us to an important philosophical perspective that emphasizes the differences between long straddles and strangles and their short counterparts. Losses from rising vega are temporary; the time value of all options will be zero at expiration. But gamma losses can be permanent and profound. These short strategies have limited profit potential and unlimited loss potential. Although short-term profits (or losses) can result from IV changes, the real goal here is to capture theta.
Short-Strangle Example
Let’srevisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this example, with an implied volatility of 26 percent and astock volatility of 22. Both implied and realized volatility are higher than has been typical during the past twelve months. John wants to sell volatility. In this example, he believes the stock price will remain in afairly tight range, causing realized volatility to revert to its normal level, in this case between 15 and 20 percent.
He does everything possible to ensure success. This includes scanning the news headlines on XYZ and its financials for areason not to sell volatility. Playing devil’sadvocate with oneself can uncover unforeseen yet valid reasons to avoid making bad trades. John also notes the recent price range, which has been between $111.71 and $102.05 over the past month. Once John commits to an outlook on the stock, he wants to set himself up for maximum gain if he’srigh


il’sadvocate with oneself can uncover unforeseen yet valid reasons to avoid making bad trades. John also notes the recent price range, which has been between $111.71 and $102.05 over the past month. Once John commits to an outlook on the stock, he wants to set himself up for maximum gain if he’sright and, for that matter, to maximize his chances of being right. In this case, he decides to sell astrangle to give himself as much margin for error as possible. He sells 10 three-week 100–110 strangles at 1.80.
Exhibit 15.11
compares the greeks of this strangle with those of the 105 straddle.
EXHIBIT 15.11
Short straddle vs. short strangle.
As expected, the strangle’sgreeks are comparable to the straddle’sbut of less magnitude. If John’sintention were to capture adrop in IV, he’dbe better off selling the bigger vega of the straddle. Here, though, he wants to see the premium at zero at expiration, so the strangle serves his purposes better. What he is most concerned about are the breakevens—in this case, 98.20 and 111.8. The straddle has closer break-even points, of $99.60 and $110.40.
Despite the fact that in this case, John is not really trading the greeks or IV per se, they still play an important role in his trade. First, he can use theta to plan the best strangle to trade. In this case, he sells the three-week strangle because it has the highest theta of the available months. The second month strangle has a −0.71 theta, and the third month has a −0.58 theta. With strangles, because the options are OTM, this disparity in theta among the tradable months may not always be the case. But for this trade, if he is still bearish on realized volatility after expiration, John can sell the next month when these options expire.
Certainly, he will monitor his risk by watching delta and gamma. These are his best measures of directional exposure. He will consider implied volatility in the decision-making process, too. An implied volatility significantly higher than the realized volatility can be ared flag that the market expects something to happen, but there’sabigger payoff if there is no significant volatility. An IV significantly lower than the realized can indicate the risk of selling options too cheaply: the premium received is not high enough, based on how much the stock has been moving. Ideally, the IV should be above the realized volatility by between 2 and 20 percent, perhaps more for highly speculative traders.
Limiting Risk
The trouble with short straddles and strangles is that every once in awhile the stock unexpectedly reacts violently, moving by three or more standard deviations. This occurs when there is atakeover, an extreme political event, alegal action, or some other extraordinary incident. These events can be guarded against by buying farther OTM options for protection. Essentially, instead of selling astraddle or astrangle, one sells an iron butterfly or iron condor. Then, when disaster strikes, it’snot acomplete catastrophe.
How Cheap Is Too Cheap?
At some point, the absolute premium simply is not worth the risk of the trade. For example, it would be unwise to sell atwo-month 45–55 strangle for 0.10 no matter what the realized volatility was. With the knowledge that there is always achance for abig move, it’shard to justify risking dollars to make adime.
Note
1
. This depends on interest, dividends, and time to expiration. The delta will likely not be exactly zero.


CHAPTER 16
Ratio Spreads and Complex Spreads
The purpose of spreading is to reduce risk. Buying one contract and selling another can reduce some or all of atrade’srisks, as measured by the greeks, compared with simply holding an outright option. But creative traders have the ability to exercise great control over their greeks risk. They can practically eliminate risk in some greeks, while retaining risks in just the desired greeks. To do so, traders may have to use more complex, and less conventional spreads. These spreads often involve buying or selling options in quantities other than one-to-one ratios.
Ratio Spreads
The simplest versions of these strategies used by retail traders, institutional traders, proprietary traders, and others are referred to as
ratio spreads
. In ratio spreads, options are bought and sold in quantities based on aratio. For example, a 1:3 spread is when one option is bought (or sold) and three are sold (or bought)—aratio of one to three. This kind of ratio spread would be called a “one-by-three.”
However, some option positions can get alot more complicated. Market makers and other professional traders manage acomplex inventory of long and short options. These types of strategies go way beyond simple at-expiration diagrams. This chapter will discuss the two most common types of ratio spreads—backspreads and ratio vertical spreads—and also the delta-neutral position management of market makers and other professional traders.
Backspreads
Definition
: An option strategy consisting of more long options than short options having the same expiration month. Typically, the trader is long calls (or puts) in one series of options and short afewer number of calls (or puts) in another series with the same expiration month in the same option class. Some traders, such as market makers, refer generically to any delta-neutral long-gamma position as abackspread.
Shades of Gray
In its simplest form, trading abackspread is trading aone-by-two call or put spread and holding it until expiration in hopes that the underlying stock’sprice will make abig move, particularly in the more favorable direction. But holding abackspread to expiration as described has its challenges. Let’slook at ahypothetical example of abackspread held to term and its at-expiration diagram.
With the stock at $71 and one month until March expiration:
In this example, there is acredit of 3.20 from the sale of the 70 call and adebit of 1.10 for each of the two 75 calls. This yields atotal net credit of 1.00 (3.20 − 1.10 − 1.10). Let’sconsider how this trade performs if it is held until expiration.
If the stock falls below $70 at expiration, all the calls expire and the 1.00 credit is all profit. If the stock is between $70 and $75 at expiration, the 70 call is in-the-money (ITM) and the −1.00 delta starts racking up losses above the breakeven of $71 (the strike plus the credit). At $75 ashare this trade suffers its maximum potential loss of $4. If the stock is above $75 at expiration, the 75 calls are ITM. The net delta of +1.00, resulting from the +2.00 deltas of the 75 calls along with the −1.00 delta of the 70 call, makes money as the stock rises. To the upside, the trade is profitable once the stock is at ahigh enough price for the gain on the two 75 calls to make up for the loss on the 70 call. In this case, the breakeven is $79 (the $4 maximum potential loss plus the strike price of 75).
While it’sgood to understand this at-expiration view of this trade, this diagram is abit misleading. What does the trader of this spread want to have happen? If the trader is bearish, he could find abetter way to trade his view than this, which limits his gains to 1.00—he could buy aput. If the trader believes the stock will make avolatile move in either direction, the backspread offers adecidedly limited opportunity to the downside. Astraddle or strangle might be abetter choice. And if the trader is bullish, he would have to be very bullish for this trade to make sense. The underlying needs to rise above $79 just to break even. If instead he just bought 2 of the 75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the breakeven would be $77.20 instead of $79, and profits at expiration would rack up twice as fast above the breakeven, since the trader is net long two calls instead of one. Why would atrader ever choose to trade abackspread?
EXHIBIT 16.1
Backspread at expiration.
The backspread is acomplex spread that can be fully appreciated only when one has athorough knowledge of options. Instead of waiting patiently until expiration, an experienced backspreader is more likely to gamma scalp intermittent opportunities. This requires trading alarge enough position to make scalping worthwhile. It also requires appropriate margining (either professional-level margin requirements or retail portfolio margining). For example, this 1:2 contract backspread has adelta of −0.02 and agamma of +0.05. Fewer than 10 deltas could be scalped if th

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ing alarge enough position to make scalping worthwhile. It also requires appropriate margining (either professional-level margin requirements or retail portfolio margining). For example, this 1:2 contract backspread has adelta of −0.02 and agamma of +0.05. Fewer than 10 deltas could be scalped if the stock moves up and down by one point. It becomes amore practical trade as the position size increases. Of course, more practical doesn’tnecessarily guarantee it will be more profitable. The market must cooperate!
Backspread Example
Let’ssay a 20:40 contract backspread is traded. (
Note
: In trader lingo this is still called aone-by-two; it is just traded 20 times.) The spread price is still 1.00 credit per contract; in this case, that’s $2,000. But with this type of trade, the spread price is not the best measure of risk or reward, as it is with some other kinds of spreads. Risk and reward are best measured by delta, gamma, theta, and vega.
Exhibit 16.2
shows this trade’sgreeks.
EXHIBIT 16.2
Greeks for 20:40 backspread with the underlying at $71.
Backspreads are volatility plays. This spread has a +1.07 vega with the stock at $71. It is, therefore, abullish implied volatility (IV) play. The IV of the long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much as with any other volatility trade, traders would compare current implied volatility with realized volatility and the implied volatility of recent past and consider any catalysts that might affect stock volatility. The objective is to buy an IV that is lower than the expected future stock volatility, based on all available data. The focus of traders of this backspread is not the dollar credit earned. They are more interested in buying a 30 volatility—that’sthe focus.
But the 75 calls’ IV is not the only volatility figure to consider. The short options, the 70s, have implied volatility of 32 percent. Because of their lower strike, the IV is naturally higher for the 70 calls. This is vertical skew and is described in Chapter 3. The phenomenon of lower strikes in the same option class and with the same expiration month having higher IV is very common, although it is not always the case.
Backspreads usually involve trading vertical skew. In this spread, traders are buying a 30 volatility and selling a 32 volatility. In trading the skew, the traders are capturing two volatility points of what some traders would call edge by buying the lower volatility and selling the higher.
Based on the greeks in
Exhibit 16.2
, the goal of this trade appears fairly straightforward: to profit from gamma scalping and rising IV. But, sadly, what appears to be straightforward is not.
Exhibit 16.3
shows the greeks of this trade at various underlying stock prices.
EXHIBIT 16.3
70–75 backspread greeks at various stock prices.
Notice how the greeks change with the stock price. As the stock price moves lower through the short strike, the 70 strike calls become the more relevant options, outweighing the influence of the 75s. Gamma and vega become negative, and theta becomes positive. If the stock price falls low enough, this backspread becomes avery different position than it was with the stock price at $71. Instead of profiting from higher implied and realized volatility, the spread needs alower level of both to profit.
This has important implications. First, gamma traders must approach the backspread alittle differently than they would most spreads. The backspread traders must keep in mind the dynamic greeks of the position. With atrade like along straddle, in which there are no short options, traders scalping gamma simply buy to cover short deltas as the stock falls and sell to cover long deltas as the stock rises. The only risks are that the stock may not move enough to cover theta or that the traders may cover deltas too soon to maximize profits.
With the backspread, the changing gamma adds one more element of risk. In this example, buying stock to flatten out delta as the stock falls can sometimes be apremature move. Traders who buy stock may end up with more long deltas than they bargained for if the stock falls into negative-gamma territory.
Exhibit 16.3
shows that with the stock at $68, the delta for this trade is −2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the stock subsequently falls to $62 ashare, instead of being short 1.46 deltas, as the figure indicates, they will be long 1.04 because of the 250 shares they bought. These long deltas start to hurt as the stock continues lower. Backspreaders must therefore anticipate stock movements to avoid overhedging. The traders in this example may decide to lean short if the stock shows signs of weakness.
Leaning short means that if the delta is −2.50 at $68 ashare, the traders may decide to underhedge by buying just 100 or 200 shares. If the stock continues to fall and negative gamma kicks in, this gives the traders some cushion to the downside. The short delta of the position moves clos


f weakness.
Leaning short means that if the delta is −2.50 at $68 ashare, the traders may decide to underhedge by buying just 100 or 200 shares. If the stock continues to fall and negative gamma kicks in, this gives the traders some cushion to the downside. The short delta of the position moves closer to being flat as the stock falls. Because there is along strike and ashort strike in this delta-neutral position, trading ratio spreads is like trading along and ashort volatility position at the same time. Trading backspreads is not an exact science. The stock has just as good achance of rising as it does of falling, and if it does rise and the traders have underhedged at $68, they will not participate in all the gains they would have if they had fully hedged by buying 250 shares of stock. If trading were easy, everyone would do it!
Backspreaders must also be conscious of the volatility of each leg of the spread. There is an inherent advantage in this example to buying the lower volatility of the 75 calls and selling the higher volatility of the 70 calls. But there is also implied risk. Equity prices and IV tend to have an inverse relationship. When stock prices fall—especially if the drop happens quickly—IV will often rise. When stock prices rise, IV often falls.
In this backspread example, as the stock price falls to or through the short strike, vega becomes negative in the face of apotentially rising IV. As the stock price rises into positive vega turf, there is the risk of IV’sdeclining. Adynamic volatility forecast should be part of abackspread-trading plan. One of the volatility questions traders face in this example is whether the two-point volatility skew between the two strike prices is enough to compensate for the potential adverse vega move as the stock price changes.
Put backspreads have the opposite skew/volatility issues. Buying two lower-strike puts against one higher-strike put means the skew is the other direction—buying the higher IV and selling the lower. The put backspread would have long gamma/vega to the downside and short gamma/vega to the upside. But if the vega firms up as the stock falls into positive-vega territory, it would be in the trader’sfavor. As the stock rises, leading to negative vega, there is the potential for vega profits if IV indeed falls. There are alot of things to consider when trading abackspread. Agood trader needs to think about them all before putting on the trade.
Ratio Vertical Spreads
Definition
: An option strategy consisting of more short options than long options having the same expiration month. Typically, the trader is short calls (or puts) in one series of options and long afewer number of calls (or puts) in another series in the same expiration month on the same option class.
Aratio vertical spread, like abackspread, involves options struck at two different prices—one long strike and one short. That means that it is avolatility strategy that may be long or short gamma or vega depending on where the underlying price is at the time. The ratio vertical spread is effectively the opposite of abackspread. Let’sstudy aratio vertical using the same options as those used in the backspread example.
With the stock at $71 and one month until March expiration:
In this case, we are buying one ITM call and selling two OTM calls. The relationship of the stock price to the strike price is not relevant to whether this spread is considered aratio vertical spread. Certainly, all these options could be ITM or OTM at the time the trade is initiated. It is also not important whether the trade is done for adebit or acredit. If the stock price, time to expiration, volatility, or number of contracts in the ratio were different, this could just as easily been acredit ratio vertical.
Exhibit 16.4
illustrates the payout of this strategy if both legs of the 1:2 contract are still open at expiration.
EXHIBIT 16.4
Short ratio spread at expiration.
This strategy is amirror image of the backspread discussed previously in this chapter. With limited risk to the downside, the maximum loss to the trade is the initial debit of 1 if the stock is below $70 at expiration and all the calls expire. There is amaximum profit potential of 4 if the stock is at the short strike at expiration. There is unlimited loss potential, since ashort net delta is created on the upside, as one short 75 call is covered by the long 70 call, and one is naked. The breakevens are at $71 and $79.
Low Volatility
With the stock at $71, gamma and vega are both negative. Just as the backspread was along volatility play at this underlying price, this ratio vertical is ashort-vol play here. As in trading ashort straddle, the name of the game is low volatility—meaning both implied and realized.
This strategy may require some gamma hedging. But as with other short volatility delta-neutral trades, the fewer the negative scalps, the greater the potential profit. Delta covering should be implemented in situations where it looks


of the game is low volatility—meaning both implied and realized.
This strategy may require some gamma hedging. But as with other short volatility delta-neutral trades, the fewer the negative scalps, the greater the potential profit. Delta covering should be implemented in situations where it looks as if the stock will trend deep into negative-gamma territory. Murphy’s Law of trading dictates that delta covering will likely be wrong at least as often as it is right.
Ratio Vertical Example
Let’sexamine atrade of 20 contracts by 40 contracts.
Exhibit 16.5
shows the greeks for this ratio vertical.
EXHIBIT 16.5
Short ratio vertical spread greeks.
Before we get down to the nitty-gritty of the mechanics and management of this trade—the how—let’sfirst look at the motivations for putting the trade on—the why. For the cost of 1.00 per spread, this trader gets aleveraged position if the stock rises moderately. The profits max out with the stock at the short-strike target price—$75—at expiration.
Another possible profit engine is IV. Because of negative vega, there is the chance of taking aquick profit if IV falls in the interim. But short-term losses are possible, too. IV can rise, or negative gamma can hurt the trader. Ultimately, having naked calls makes this trade not very bullish. Abig move north can really hurt.
Basically, this is adelta-neutral-type short-volatility play that wins the most if the stock is at $75 at expiration. One would think about making this trade if the mechanics fit the forecast. If this trader were amore bullish than indicated by the profit and loss diagram, amore-balanced bull call spread would be abetter strategy, eliminating the unlimited upside risk. If upside risk were acceptable, this trader could get more aggressive by trading the spread one-by-three. That would result in acredit of 0.05 per spread. There would then be no ultimate risk below $70 but rather a 0.05 gain. With double the naked calls, however, there would be double punishment if the stock rallied strongly beyond the upside breakeven.
Ultimately, mastering options is not about mastering specific strategies. It’sabout having athorough enough understanding of the instrument to be flexible enough to tailor aposition around aforecast. It’sabout minimizing the unwanted risks and optimizing exposure to the intended risks. Still, there always exists atrade-off in that where there is the potential for profit, there is the possibility of loss—you can always be wrong.
Recalling the at-expiration diagram and examining the greeks, the best-case scenario is intuitive: the stock at $75 at expiration. The biggest theta would be right at that strike. But that strike price is also the center of the biggest negative gamma. It is important to guard against upward movement into negative delta territory, as well as movement lower where the position has aslightly positive delta.
Exhibit 16.6
shows what happens to the greeks of this trade as the stock price moves.
EXHIBIT 16.6
Ratio vertical spread at various prices for the underlying.
As the stock begins to rise from $71 ashare, negative deltas grow fast in the short term. Careful trend monitoring is necessary to guard against arally. The key, however, is not in knowing what will happen but in skillfully hedging against the unknown. The talented option trader is adisciplined risk manager, not aclairvoyant.
One of the risks that the trader willingly accepted when placing this trade was short gamma. But when the stock moves and deltas are created, decisions have to be made. Did the catalyst(s)—if any—that contributed to the rise in stock price change the outlook for volatility? If not, the decision is simply whether or not to hedge by buying stock. However, if it appears that volatility is on the rise, it is not just adelta decision. Atrader may consider buying some of the short options back to reduce volatility exposure.
In this example, if the stock rises and it’sfeared that volatility may increase, agood choice may be to buy back some of the short 75-strike calls. This has the advantage of reducing delta (buy enough deltas to flatten out) and reducing gamma and vega. Of course, the downside to this strategy is that in purchasing the calls, aloss is likely to be locked in. Unless alot of time has passed or implied volatility has dropped sharply, the calls will probably be bought at ahigher price than they were sold.
If the stock makes aviolent move upward, aloss will be incurred. Whether this loss is locked in by closing all or part of the position, the account will still be down in value. The decision to buy the calls back at aloss is based on looking forward. Nothing good can come of looking back.
How Market Makers Manage Delta-Neutral Positions
While market makers are not position traders per se, they are expert position managers. For the most part, market makers make their living by buying the bid and selling the offer. In general, they don’tact; they react. Most of their trades are initi


.
How Market Makers Manage Delta-Neutral Positions
While market makers are not position traders per se, they are expert position managers. For the most part, market makers make their living by buying the bid and selling the offer. In general, they don’tact; they react. Most of their trades are initiated by taking the other side of what other people want to do and then managing the risk of the positions they accumulate.
The business of amarket maker is much like that of acasino. Acasino takes the other side of people’sbets and, in the long run, has astatistical (theoretical) edge. For market makers, because theoretical value resides in the middle of the bid and the ask, these accommodating trades lead to atheoretical profit—that is, the market maker buys below theoretical value and sells above. Actual profit—cold, hard cash you can take to the bank—is, however, dependent on sound management of the positions that are accumulated.
My career as amarket maker was on the floor of the Chicago Board Options Exchange (CBOE) from 1998 to 2005. Because, over all, the trades Imade had atheoretical edge, Ihoped to trade as many contracts as possible on my markets without getting too long or too short in any option series or any of my greeks.
As aresult of reacting to order flow, market makers can accumulate alarge number of open option series for each class they trade, resulting in asingle position. For example,
Exhibit 16.7
shows aposition Ihad in Ford Motor Co. (F) options as amarket maker.
EXHIBIT 16.7
Market-maker position in Ford Motor Co. options.
With all the open strikes, this position is seemingly complex. There is not aspecific name for this type of “spread.” The position was accumulated over along period of time by initiating trades via other traders selling options to me at prices Iwanted to buy them—my bid—and buying options from me at prices Iwanted to sell them—my offer. Upon making an option trade, Ineeded to hedge directional risk immediately. Iusually did so by offsetting my option trades by taking the opposite delta position in the stock—especially on big-delta trades. Through this process of providing liquidity to the market, Ibuilt up option-centric risk.
To manage this risk Ineeded to watch my other greeks. To be sure, trying to draw a P&Ldiagram of this position would be afruitless endeavor.
Exhibit 16.8
shows the risk of this trade in its most distilled form.
EXHIBIT 16.8
Analytics for market-maker position in Ford Motor Co. (stock at $15.72).
Delta
+1,075
Gamma
−10,191
Theta
+1,708
Vega
+7,171
Rho
−33,137
The +1,075 delta shows comparatively small directional risk relative to the −10,191 gamma. Much of the daily task of position management would be to carefully guard against movement by delta hedging when necessary to earn the $1,708 per day theta.
Much of the negative gamma/positive theta comes from the combined 1,006 short January 15 calls and puts. (Note that because this position is traded delta neutral, the net long or short options at each strike is what matters, not whether the options are calls or puts. Remember that in delta-neutral trading, aput is acall, and acall is aput.) The positive vega stems from the fact that the position is long 1,927 January 2003 20-strike options.
Although this position has alot going on, it can be broken down many ways. Having long LEAPS options and short front-month options gives this position the feel of atime spread. One way to think of where most of the gamma risk is coming from is to bear in mind that the 15 strike is synthetically short 503 straddles (1,006 options ÷ two). But this position overall is not like astraddle. There are more strikes involved—alot more. There is more short gamma to the downside if the price of Ford falls toward $12.50. To the upside, the 17.50 strike is long acombined total of 439 options. Looking at just the 15 and 17.50 strikes, we can see something that looks more like aratio spread: 1,006:439. If the stock were at $17.50, the gamma would be around +5,000.
With the stock at $15.72, there is realized volatility risk of Frallying, but with gamma changing from negative to positive as the stock rallies, the risk of movement decreases quickly. The 20 strike is short 871 options which brings the position back to negative-gamma territory. Having alternating long and short strikes, sometimes called abutterflied position, is ahandy way for market makers to reduce risk. Aposition is perfectly butterflied if it has alternating long and short strikes with the same number of contracts.
Through Your Longs to Your Shorts
With market-maker-type positions consisting of many strikes, the greatest profit is gained if the underlying security moves through the longs to the shorts. This provides kind of awin-win scenario for greeks traders. In this situation, traders get the benefit of long gamma as the stock moves higher or lower through the long strike. They also reap the benefits of theta when the stock sits at the short strike.
Trading Fla


through the longs to the shorts. This provides kind of awin-win scenario for greeks traders. In this situation, traders get the benefit of long gamma as the stock moves higher or lower through the long strike. They also reap the benefits of theta when the stock sits at the short strike.
Trading Flat
Most market makers like to trade flat—that is, profit from the bid-ask spread and strive to lower exposure to direction, time, volatility, and interest as much as possible. But market makers are at the mercy of customer orders, or paper, as it’sknown in the industry. If someone sells, say, the March 75 calls to amarket maker at the bid, the best-case scenario is that moments later someone else buys the same number of the same calls—the March 75s, in this case—from that same market maker at the offer. This is locking in aprofit.
Unfortunately, this scenario seldom plays out this way. In my seven years as amarket maker, Ican count on one hand the number of times the option gods smiled upon me in such away as to allow me to immediately scalp an option. Sometimes, the same option will not trade again for aweek or longer. Very low-volume options trade “by appointment only.” Amarket maker trading illiquid options may hold the position until it expires, having no chance to get out at areasonable price, often taking aloss on the trade.
More typically, if amarket maker buys an option, he must sell adifferent option to lessen the overall position risk. The skills these traders master are to lower bids and offers on options when they are long gamma and/or vega and to raise bids and offers on options when they are short gamma and/or vega. This raising and lowering of markets is done to manage risk.
Effectively, this is your standard high school economics supply-and-demand curves in living color. When the market demands (buys) all the options that are supplied (offered) at acertain price, the price rises. When the market supplies (sells) all the options demanded (bid) at aprice level, the price falls. The catalyst of supply and demand is the market maker and his risk tolerance. But instead of the supply and demand for individual options, it is supply and demand for gamma, theta, and vega. This is trading option greeks.
Hedging the Risk
Delta is the easiest risk for floor traders to eliminate quickly. It becomes second nature for veteran floor traders to immediately hedge nearly every trade with the underlying. Remember, these liquidity providers are in the business of buying option bids and selling option offers, not speculating on direction.
The next hurdle is to trade out of the option-centric risk. This means that if the market maker is long gamma, he needs to sell options; if he’sshort gamma, he needs to buy some. Same with theta and vega. Market makers move their bids and offers to avoid being saddled with too much gamma, theta, and vega risk. Experienced floor traders are good at managing option risk by not biting off more than they can chew. They strive to never buy or sell more options than they can spread off by selling or buying other options. This breed of trader specializes in trading the spread and managing risk, not in predicting the future. They’re market makers, not market takers.
Trading Skew
There are some trading strategies for which market makers have anatural propensity that stems from their daily activity of maintaining their positions. While money managers who manage equity funds get to know the fundamentals of the stocks they trade very well, options market makers know the volatility of the option classes they trade. When they adjust their markets in reacting to order flow, it’s, mechanically, implied volatility that they are raising or lowering to change theoretical values. They watch this figure very carefully and trade its subtle changes.
Acharacteristic of options that many market makers and some other active professional traders observe and trade is the volatility skew. Savvy traders watch the implied volatility of the strikes above the at-the-money (ATM)—referred to as
calls
, for simplicity—compared with the strikes below the ATM, referred to as
puts
. In most stocks, there typically exists a “normal” volatility skew inherent to options on that stock. When this skew gets out of line, there may be an opportunity.
Say for aparticular option class, the call that is 10 percent OTM typically trades about four volatility points lower than the put that is 10 percent OTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher, say, nine points above where the calls are offered—for instance, the puts are bid at 32 volatility bid while the calls are offered at 23 vol—atrader can speculate on the skew reverting back to its normal relationship by selling the puts, buying the calls, and hedging the delta by selling the right amount of stock.
This position—long acall, short aput with adifferent strike, and short stoc