The Big V
Gamma and theta are not alone in the straddle buyer’s thoughts. Vega is a
major consideration for a straddle buyer, as well. In a straddle, there are two
long options of the same strike, which means double the vega risk of a
single-leg trade at that strike. With no short options in this spread, the
implied-volatility exposure is concentrated. For example, if the call has a
vega of 0.05, the put’s vega 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 a prime 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 a straddle
that it is not too expensive in terms of the implied volatility. A winning
gamma trade can quickly become a loser 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 a trade’s vega 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’s volatility 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