The wittier headline would have been The Case for Apple Strudels Straddles but yours truly couldn’t figure out how to do strike-through text in my heading.
The life of a straddle buyer could properly be characterized as perpetual disappointment punctuated by the occasional flash of brilliance. Over time the long straddle produces many losers and few winners. Chalk this fact up to the so-called volatility risk premium which exists when the implied volatility built into an option’s price is higher than the subsequent volatility realized by the underlying asset throughout the life of the option. In simple terms options are persistently overpriced. And since the long straddle involves purchasing both a call and a put option it’s a tough trade to consistently make money with.
While many tout the long straddle as a bi-directional trade, let’s not forget it is at its heart a long volatility play. To say the purchase of a straddle is a bet that a stock will move up or down is a bit misleading. In reality it is a bet that the stock will move not just up or down, but up or down MORE than expected. You’re effectively betting the option market has it wrong, that it is underpricing the volatility soon to be realized by the underlying asset.
The successful implementation of long straddles then is a byproduct of impeccable timing. It requires identifying environments of opportunity where a volatility explosion is imminent and option premiums are on the cheap. Such a setup is often revealed through the compression of Bollinger Bands, the formation of a symmetrical triangle, or other such signals of a coming volatility surge. Yet, the identification of such a setup is merely half the battle. One must also assess a volatility chart to ascertain the relative cheapness of option prices. In the event implied volatility is low enough, long straddles may indeed prove fruitful.
Technology rock star Apple Inc (AAPL) currently provides a compelling case study for the long straddle. From a chart perspective is has been basing for over a month in the $570-$580 area. In volatility terms we’d say the stock is coiling or experiencing a compression in volatility as reflected by the Bollinger Bands which have narrowed in recent days to their tightest levels in over six months. If you subscribe to the notion that volatility regimes alternate between periods of expansion and compression then you’re likely in the camp that contends a volatility expansion is looming.
At the same time implied volatility (VXAPL) is approaching the lower level of its multi-year range making options appear somewhat cheap relative to where they usually trade. In addition Apple’s Q2 earnings are set to be released in July so one would expect the typical pre-earnings volatility bid-up heading into the event.
So this is a long way of saying straddle buys make more sense now in AAPL than they have in awhile. And if you count yourselves among the ranks of those who shudder at the thought of buying a straddle, then by all means do something else. All I’m saying is buying volatility here looks more appealing than selling it.