The Rough Road for Straddle Buyers

by Tyler Craig on June 19, 2012

Post image for The Rough Road for Straddle Buyers

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.

[Source:  MachTrader]

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.

For related posts readers can check out:
Options and the Volatility Risk Premium
The Notoriously Difficult Straddle Play
Low Volatility, A Siren Song?

{ 6 comments… read them below or add one }

Gav June 20, 2012 at 2:00 pm

Totally agree with you here, although personally I prefer strangles. Which expiry month would you look at? I was looking at October with a view to selling the strangle around August, unless the big move comes sooner.

Reply

Tyler Craig June 21, 2012 at 10:37 am

Hi Gav,

Thanks for the inclusion in your website links. First off I don’t typically employ long straddles for a lot of the reasons outlined in the post. But if I were trying to game the current setup then I’d actually look at shorter dated long straddles like July or August. Yeah the higher rate of time decay bites but the IV on shorter dated options have come in quite a bit more than longer dated ones (I’m using Livevol for this and comparing IV 30 to IV 60 and IV 90). In addition if I were banking on a rise in IV heading into earnings to help the play then it’s going to be most influential on July and Aug options, not October. No doubt there are a few different ways you could structure positions around this, but these are my thoughts for the long straddle FWIW.

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Loren June 20, 2012 at 3:58 pm

What platform are you able to chart the IV graph above?

The lowest I can get on bloomberg is right around 30, however I’m sure I’m doing something wrong

Reply

Tyler Craig June 21, 2012 at 10:24 am

Hi Loren,

The charting platform I use is MachTrader. It uses Esignal as its data provider. The chart is VXAPL. The CBOE offers Volatility Indexes (http://www.cboe.com/micro/equityvix/introduction.aspx) on a few popular stocks – AAPL, GOOG, GS, IBM, AMZN. So if you know the ticker symbol you can chart them on any platform. For stocks that don’t have these volatility indexes I use Livevol Pro or http://www.ivolatility.com for implied volatility charts.

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Simon June 22, 2012 at 3:05 am

Nice example of how technical/directional analysis can be used to suggest volatility plays. One question is whether you ever gamma hedge your straddles or do you keep them as a strict directional play? It would interesting to know whether, on average, the kind of approach you outlined is more effective when the volatility is scalped intra-day or when the straddles are left un-hedged. Obviously the second approach is a lot more ‘binary’ in terms of its outcome, but cheaper to manage and perhaps more in tune with an overall ‘directional’ strategy.
Interesting blog. Congrats.
Simon

Reply

Tyler Craig June 22, 2012 at 9:15 am

You bring up some great questions. I suppose the key phrase in your questions is “on average” as you will have situations where un-hedged straddles outperform and others where gamma scalping turns out to be the superior situation. To be honest I don’t employ the strategy enough to provide an answer based on my own experience. In the event the underlying asset stages a strong directional move, the unhedging approach trumps. If the asset follows a more choppy/mean reversion path I suspect the hedging route would be better. As you mention the scalping approach would increase slippage and commission making a low cost broker a must.

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