194 lines
40 KiB
Plaintext
194 lines
40 KiB
Plaintext
CHAPTER 15
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Straddles and Strangles
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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.
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Long Straddle
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Definition
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: Buying one call and one put in the same option class, in the same expiration cycle, and with the same strike price.
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Linearly, the long straddle is the best of both worlds—long a call and a put. If the stock rises, the call enjoys the unlimited potential for profit while the put’s losses are decidedly limited. If the stock falls, the put’s profit potential is bound only by the stock’s falling to zero, while the call’s potential loss is finite. Directionally, this can be a win-win situation—as long as the stock moves enough for one option’s profit to cover the loss on the other. The risk, however, is that this may not happen. Holding two long options means a big penalty can be paid for stagnant stocks.
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The Basic Long Straddle
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The long straddle is an option strategy to use when a trader is looking for a big move in a stock 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 a breakout. Or fundamental data might call for a revaluation of the stock based on an impending catalyst. In either case, a long straddle, is a way for traders to position themselves for the expected move, without regard to direction. In this example, we’ll study a hypothetical $70 stock poised for a breakout. We’ll buy the one-month 70 straddle for 4.25.
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Exhibit 15.1
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shows the payout of the straddle at expiration.
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EXHIBIT 15.1
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At-expiration diagram for a long straddle.
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At expiration, with the stock at $70, neither the call nor the put is in-the-money. The straddle expires worthless, leaving a loss 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.
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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 a winner, 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 a winner, and the lower, the better.
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Why It Works
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In this basic example, if the underlying is beyond either of the break-even points at expiration, the trade is a winner. 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.
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In practice, most active traders will not hold a straddle 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 a race against the clock—a race against theta. Theta is the cost of trading the long straddle. Only pay it for as long as necessary. When the stock’s volatility appears poised to ebb, exit the trade.
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Exhibit 15.2
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shows the P&(L) of the straddle both at expiration and at the time the trade was made.
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EXHIBIT 15.2
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Long straddle P&(L) at initiation and expiration.
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Because this is a short-term at-the-money (ATM) straddle, we will assume for simplicity that it has a delta of zero.
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1
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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 a decreasing rate. When the stock moves lower, the put gains at an increasing rate while the call loses at a decreasing rate. This is positive gamma.
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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.
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The potential for gamma scalping is an important motivation for straddle buyers. Gamma scalping a straddle gives traders the chance to profit from a stock that has dynamic price swings. It should be second nature to volatility traders to understand that theta is the trade-off of gamma scalping.
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The Big V
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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.
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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.
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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.
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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 options. In this case, traders would need to buy the month that they think is cheap.
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Trading the Long Straddle
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Option trading is all about optimizing the statistical chances of success. A long-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 a straddle just before earnings are announced because they anticipate a big 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 a hard way to make money.
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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 a stock 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.
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As in analyzing a stock, 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.
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With all trading, getting in is easy. It’s managing 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 a big 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 a promising opportunity.
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Legging Out
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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.
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A trader, Susan, has been studying Acme Brokerage Co. (ABC). Susan has noticed that brokerage stocks have been fairly volatile in recent past.
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Exhibit 15.3
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shows an analysis of Acme’s volatility over the past 30 days.
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EXHIBIT 15.3
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Acme Brokerage Co. volatility.
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Stock Price
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Realized Volatility
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Front-Month Implied Volatility
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30-day high $78.66
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30-day high 47%
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30-day high 55%
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30-day low $66.94
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30-day low 36%
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30-day low 34%
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Current px $74.80
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Current vol 36%
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Current vol 36%
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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.
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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.
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Exhibit 15.4
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shows the analytics of this trade with four weeks until expiration.
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EXHIBIT 15.4
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Analytics for long 20 Acme Brokerage Co. 75-strike straddles.
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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 a day just to break even against the time decay. And if IV continues to ebb down to a lower, more historically normal, level, she needs to scalp even more to make up for vega losses.
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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 a higher 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 a volatility 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.
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Week One
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During the first week, the stock’s volatility tapered off a bit 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’t cover her seven days of theta. Her stock buys and sells netted a gain 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.
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Susan decided to hold her position. Toward the end of week two, there would be the Federal Open Market Committee (FOMC) meeting.
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Week Two
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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.
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By week’s end, 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 a bit 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 a result of the big moves during the week that were factored into the 30-day calculation.
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With seven more days of decay and a lower 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.
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What went into Susan’s decision to close her position? Susan had two objectives: to profit from a rise in implied volatility and to profit from a rise 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.
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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.
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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 a certain loser. Even though implied volatility had risen four points by Tuesday of the second week, the trade did not yield a profit. The time decay of holding two options can make long straddles a tough strategy to trade.
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Short Straddle
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Definition
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: Selling one call and one put in the same option class, in the same expiration cycle, and with the same strike price.
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Just as buying a straddle is a pure way to buy volatility, selling a straddle is a way to short it. When a trader’s forecast calls for lower implied and realized volatility, a straddle generates the highest returns of all volatility-selling strategies. Of course, with high reward necessarily comes high risk. A short straddle is one of the riskiest positions to trade.
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Let’s look at a one-month 70-strike straddle sold at 4.25.
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The risk is easily represented graphically by means of a P&(L) diagram.
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Exhibit 15.5
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shows the risk and reward of this short straddle.
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EXHIBIT 15.5
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Short straddle P&(L) at initiation and expiration.
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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 a whole will be a loser 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.
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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 a loser. 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.
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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.
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It’s important to note that just because neither option is ITM if the underlying is right at $70 at expiration, it doesn’t mean 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 a pleasant 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 a position in the underlying security—is a risk 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 a small price to pay when one considers the possibility of waking up Monday morning to find a loss of hundreds of dollars per contract because a position you didn’t even know you owned had moved against you. Most traders avoid this risk, referred to as pin risk, by closing short options before expiration.
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The Risks with Short Straddles
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Looking at an at-expiration diagram or even analyzing the gamma/theta relationship of a short straddle may sometimes lead to a false sense of comfort. Sometimes it looks as if short straddles need a pretty big move to lose a lot of money. So why are they definitely among the riskiest strategies to trade? That is a matter of perspective.
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Option trading is about risk management. Dealing with a proverbial train wreck every once in a while is part of the game. But the big disasters can end one’s trading career in an instant. Because of its potential—albeit sometimes small potential—for a colossal blowup, the short straddle is, indeed, one of the riskiest positions one can trade. That said, it has a place in the arsenal of option strategies for speculative traders.
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Trading the Short Straddle
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A short straddle is a trade for highly speculative traders who think a security will trade within a defined range and that implied volatility is too high. While a long straddle needs to be actively traded, a short 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 a short straddle, every stock trade locks in a loss 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.
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Short-straddle traders must take a longer-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’s erosion, short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game.
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There are some situations that are exceptions to this long-term focus. For example, when implied volatility gets to be extremely high for a particular option class relative to both the underlying stock’s volatility and the historical implied volatility, one may want to sell a straddle to profit from a fall in IV. This can lead to leveraged short-term profits if implied volatility does, indeed, decline.
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Because of the fact that there are two short options involved, these straddles administer a concentrated dose of negative vega. For those willing to bet big on a decline in implied volatility, a short straddle is an eager croupier. These trades are delta neutral and double the vega of a single-leg trade. But they’re double the gamma, too. As with the long straddle, realized and implied volatility levels are both important to watch.
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Short-Straddle Example
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For this example, a trader, John, has been watching Federal XYZ Corp. (XYZ) for a year. 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 a bit more volatile.
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Exhibit 15.6
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shows XYZ’s recent volatility.
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EXHIBIT 15.6
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XYZ volatility.
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Stock Price
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Realized Volatility
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Front-Month Implied Volatility
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30-day high $111.71
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30-day high 26%
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30-day high 30%
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30-day low $102.05
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30-day low 21%
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30-day low 24%
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Current px $104.75
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Current vol 22%
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Current vol 26%
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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 a channel. 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’s historically high compared with the 20 percent level that John has been used to seeing, and it’s still 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.
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Exhibit 15.7
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shows the greeks for this trade.
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EXHIBIT 15.7
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Greeks for short XYZ straddle.
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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.
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Week One
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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.
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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.
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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.
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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.
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Week Two
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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 sinking 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 a winner if John bought it back at this point.
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Gamma/delta hurt. Theta helped. A characteristic that enters into this trade is volatility’s changing as a result 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’s rise in price is very common in many equity and index options. John decided to close the trade. Nobody ever went broke taking a profit.
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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’s trade would have been ugly.
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Synthetic Straddles
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Straddles are the pet strategy of certain professional traders who specialize in trading volatility. In fact, in the mind of many of these traders, a straddle is all there is. Any single-legged trade can be turned into a straddle synthetically simply by adding stock.
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Chapter 6 discussed put-call parity and showed that, for all intents and purposes, a put is a call and a call is a put. 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 a matter of perspective, one can make the case that buying two calls is essentially the same as buying a call and a put, once stock enters into the equation.
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Take a non-dividend-paying stock trading at $40 a share. 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:
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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.
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Combined, the long call and the synthetic long put (long call plus short stock) creates a synthetic straddle. A long synthetic straddle could have similarly been constructed with a long put and a long synthetic call (long put plus long stock). Furthermore, a short synthetic straddle could be created by selling an option with its synthetic pair.
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Notice the similarities between the greeks of the two positions. The synthetic straddle functions about the same as a conventional 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 a bit 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.
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Long Strangle
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Definition
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: 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. A strangle in which an ITM call and an ITM put are purchased is called a long guts strangle.
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A long strangle is similar to a long straddle in many ways. They both require buying a call and a put 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.
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Because there is distance between the strike prices, from an at-expiration perspective, the underlying must move more for the trade to show a profit.
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Exhibit 15.8
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illustrates the payout of options as part of a long strangle on a $70 stock. The graph is much like that of
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Exhibit 15.1
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, which shows the payout of a long 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:
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EXHIBIT 15.8
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Long strangle at-expiration diagram.
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The underlying has a bit 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.
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An important difference between a straddle and a strangle is that if a strangle is held until expiration, its break-even points are farther apart than those of a comparable straddle. The 70-strike straddle in
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Exhibit 15.1
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had a lower 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.
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But what if the strangle is not held until expiration? Then the trade’s greeks 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 a two-handed implication when comparing straddles and strangles.
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On the one hand, from a realized volatility perspective, lower gamma means the underlying must move more than it would have to for a straddle to produce the same dollar gain per spread, even intraday. But on the other hand, lower theta means the underlying doesn’t have to move as much to cover decay. A lower nominal profit but a higher percentage profit is generally reaped by strangles as compared with straddles.
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A long 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.
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Say a trader expects implied volatility to rise as a result 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 a straddle, the stock will be moving away from the point with the highest vega. If the stock doesn’t move as anticipated, the lower theta and vega of the strangle compared with the ATM straddle have a less adverse effect on P&L.
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Long-Strangle Example
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Let’s return to Susan, who earlier in this chapter bought a straddle on Acme Brokerage Co. (ABC). Acme currently trades at $74.80 a share with current realized volatility at 36 percent. The stock’s volatility 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.
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As in the long-straddle example earlier in this chapter, there is a great 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’s time about whose possible actions analysts’ estimates vary greatly, from a cut of 50 basis points to no cut at all. Add a pending earnings release to the docket, and Susan thinks Acme may move quite a bit.
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In this case, however, instead of buying the 75-strike straddle, Susan pays 2.35 for 20 one-month 70–80 strangles.
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Exhibit 15.9
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compares the greeks of the long ATM straddle with those of the long strangle.
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EXHIBIT 15.9
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Long straddle versus long strangle.
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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, a strangle would enjoy profits from movement and losses from lack of movement that were similar to those of a straddle—just nominally less extreme.
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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 a gain 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.
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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 a vega of 2.66, while the strangle’s vega would be 2.67 with the underlying at $79.80 per share.
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Short Strangle
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Definition
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: 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. A strangle in which an ITM call and an ITM put are sold is called a short guts strangle.
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A short strangle is a volatility-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 a higher chance of success is lower option premium.
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Exhibit 15.10
|
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shows the at-expiration diagram of a short strangle sold at 1.00, using the same options as in the diagram for the long strangle.
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||
EXHIBIT 15.10
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Short strangle at-expiration diagram.
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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 a loser. 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 a loser. The higher the stock, the bigger the loss.
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Intuitively, the signs of the greeks of this strangle should be similar to those of a short 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.
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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.
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||
Short-Strangle Example
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||
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.
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||
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.
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||
Exhibit 15.11
|
||
compares the greeks of this strangle with those of the 105 straddle.
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||
EXHIBIT 15.11
|
||
Short straddle vs. short strangle.
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||
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 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.
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||
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.
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||
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 a red flag that the market expects something to happen, but there’s a bigger 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.
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||
Limiting Risk
|
||
The trouble with short straddles and strangles is that every once in a while the stock unexpectedly reacts violently, moving by three or more standard deviations. This occurs when there is a takeover, an extreme political event, a legal action, or some other extraordinary incident. These events can be guarded against by buying farther OTM options for protection. Essentially, instead of selling a straddle or a strangle, one sells an iron butterfly or iron condor. Then, when disaster strikes, it’s not a complete catastrophe.
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||
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 a two-month 45–55 strangle for 0.10 no matter what the realized volatility was. With the knowledge that there is always a chance for a big move, it’s hard to justify risking dollars to make a dime.
|
||
Note
|
||
1
|
||
. This depends on interest, dividends, and time to expiration. The delta will likely not be exactly zero. |