Trading the Long Straddle

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. 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.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.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.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. A trader, Susan, has been studying Acme Brokerage Co. (ABC). Susan has noticed that brokerage stocks have been fairly volatile in recent past.Exhibit 15.3 shows an analysis of Acme’s volatility over the past 30 days.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.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.Exhibit 15.4 shows the analytics of this trade with four weeks until expiration.As with any trade, the risk is that the trader is wrong. The risk here is indicated by the 22.07 theta and the 13.35 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.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.