Short-Strangle Example
Let’s revisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this
example, with an implied volatility of 26 percent and a stock 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 a fairly 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 a reason not to sell volatility.
Playing devil’s advocate 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’s right and, for that matter, to maximize his chances of
being right. In this case, he decides to sell a strangle 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’s greeks are comparable to the straddle’s but of
less magnitude. If John’s intention were to capture a drop in IV, he’d be