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 a two-week examination of one
possible outcome for John’s trade.
Week One
The first week in this example was a profitable one, but it came with
challenges. John paid for his winnings with a few sleepless nights. On the
Monday following his entry into the trade, the stock rose to $106. While
John collected a weekend’s worth 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 a profit, but his position delta began to
grow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75
stock, a move 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 a stop
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 a short
straddle, a $3.50 gap move in the underlying tends to instantly give you a