Volatility and Deaf Possums

by Tyler Craig on July 2, 2012

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Monitoring Apple’s price action of late has been like watching a possum play dead.  Bulls and bears have congregated about the rodent poking with sharp sticks in an attempt to illicit some type of reaction.  Yet there it sits, reacting not a whit. “Move!” they bellow in a collective chorus.  Perhaps they’ve stumbled upon the rare breed of deaf possums.  It appears what was thought to be an imminent breakout morphed into a looming breakout which morphed yet again into a breakout which may or may not transpire at some point, or at no point, in the future.

Of course, my sarcasm is bleeding through, but the point is valid.  Anticipating a bottom in implied volatility coupled with a surge in realized volatility is often easier said then done, especially if your instrument of choice is a long straddle.  Think of the straddle as a race between time decay and sufficient price movement.  In the event you purchase the straddle you’re betting price movement will come out the victor.  In other words, the long options will accumulate enough intrinsic value to offset the time decay that is plaguing the position day-by-day.

Unfortunately the recent race in Apple has been a one-sided slaughter with time decay winning virtually every single day.  Need a numerical example?

Let’s say on June 14 with AAPL trading at $573 you purchased the July 570-575 strangle for $37.30.  At trade entry your position delta was effectively zero (neutral) while your theta was -52.  Given that your position is hemorrhaging $52 a day the hope is that you acquire greater than $52 per day due to the straddle gaining intrinsic value, implied volatility lifting, or a combination of the two.  Sadly, such has not been the case.  While theta has engaged in its daily acts of thievery, the inability of AAPL to venture more than a stone’s throw away from the $573 level as well as implied volatility’s reticence to lift much from trade entry levels has thus far spelled disaster for straddle buyers.  As of Friday’s close the 570-575 strangle was trading for a paltry $24.40, down $1290 from trade entry.

Might the quarterly pre-earnings ramp in price and volatility swoop in to save the trade?  Perhaps.  One thing is for sure, those who acted early with long straddles/strangles on the opportunity spelled out in my prior post have been punished.  An adjustment worth consideration for long straddle advocates might be to wait for an uptick in realized volatility (via a price breakout) before acquiring their positions. Or perhaps simply monitor the value of the straddle in question and wait for it to begin to pick up in value before pulling the trigger.  In the AAPL case study mentioned above I’m pretty sure the straddle dropped in value virtually every day.

{ 1 comment… read it below or add one }

Joseph Walker July 19, 2012 at 3:04 pm

The article is spot on. The only problem I see is that a Possum is a marsupial, not a rodent.

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