Legging Out
There are many ways to exiting a straddle. 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.
A trader, 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’s volatility over the past 30 days.
EXHIBIT 15.3 Acme Brokerage Co. volatility.
Stock Price Realized VolatilityFront-Month Implied Volatility
30-day high $78.6630-day high 47%30-day high 55%
30-day low $66.9430-day low 36%30-day low 34%
Current px $74.80Current vol 36%Current vol 36%
During this period, Acme stock ranged more than $11 in price. In this
example, Acme’s volatility is a function of interest rate concerns and other
macroeconomic issues affecting the brokerage industry as a whole. 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 a brokerage 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 a volatility-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.