As you probably knew well enough before you picked up this book, and as we saw in some detail in Chapter 6, many futures markets tend to move upward or downward during specific times of the year. That’s just fine with us,and you and I certainly should be prepared to exploit the opportunities these tendencies present. When we buy straddles, however, we are by definition not interested in direction, but rather only in the amount of movement the market is likely to see.
This attitude is advantageous to us because such movement, historically, is easily calculated. We can, if we like, employ good old SV as a possible measure of the likelihood of X amount of movement,but I prefer a simpler tool. Let’s just examine the gross movement of a couple of markets during each month for the last few years. Tables 8.1 and 8.2 present such examinations of the NYBOT frozen concentrated orange juice (OJ) contract.
To produce these tables, I’ve used the closest futures contract that spans a whole month, no partial months allowed. The reason for constructing the study in this fashion is that orange juice futures expire in the middle of the month. Sticking to whole months allows us to avoid any skewing of the data by omitting any price shenanigans that may have occurred during the last few days of a contract’s life.
The orange juice market’s futures contracts open every two months, in January, March, May, and so on. Therefore, for the March 2000 futures, the studies have used the price data from January 1, 2000 through February 29, 2000, and the same construction applies for all the other contracts in the studies.From the longer-term study in Table 8.1, it’s very easy to see over which months the OJ futures historically have had their largest gross movement.
Obviously, we want to own November straddles going into the fall, the August–September–October period showing a high gross movement. Similarly,we’d like to own March straddles into the December–January–February period. The shorter-term study (Table 8.2) confirms this, generally. And, I believe that we can fairly say that owning July straddles over the April–May–June period is probably quite unsatisfactory.
However, as you correctly suppose (you know my methods by now, Watson), there’s more to it than this. We can extend our advantage by looking at two more factors, one of which is specific to the year in which we are trading. Selecting Volatility—Avoiding the Dreaded Premium Sag As we saw in Chapter 3, the volatilities of a market change over time. This applies to both the market’s SV and its options’ IV.
The present level of a market’s volatility is of considerable concern to straddle buyers. If it happens to be up in the clouds when we purchase the straddle, we are accepting the risk of a decline in volatility. IV is the important one here, because we are dealing in options, and IV is a representation of the level of options’ time premiums.There’s no need for us to accept this extra risk and doing so would be just plain careless, in addition to likely being costly.
Prior to buying the straddle,we must examine the relative IVs of the market we’re considering.If the IVs of the options on the market we want to straddle are to the high end of their historical range (and I always use the previous 6-month range of the IVs of the options for this analysis), then we’ll look at another market. There’s no point and little profit to be made in buying straddles in a market with lofty IVs, unless we’ve some outstanding reason to expect a continuing high volatility in that market.
When we buy straddles that have IVs at skyscraper levels, we might ultimately profit if IV stays up or moves higher.If, though, especially early in the term of our trade, these high IVs (and hence the option premiums) develop a case of Cooper’s droop, we are largely helpless.We’ll become dependent on a sizeable move in the underlying market to return our trade to profitability.
Now, such a move might indeed occur,but I intensely dislike “might” as a parameter of trading. “Is likely to” is much,much more friendly to our trading capital.We’d strongly prefer, in fact I make it a condition of entry, to buy straddles in markets whose options’ IV is specifically in the lowest quintile, the lowest 20% of their 6-month range.
This policy eliminates the great bulk of the so-called sag risk from declining volatility and gives us the additional possibility of being aided by a rise in IV during the term of the trade, a very profitable double advantage when such a rise occurs. We could easily be more conservative still, and only consider buying straddles when IVs are in the bottom 10% of the recent range. This policy is fine, and very disciplined,but will unfortunately and smartly reduce the number of good straddle op-portunities we see, perhaps by as much as two-thirds. It’s your call here.