What are straddles?

With the implied volatility of the S&P 500 Index (as represented by the VIX) touching 18 and the 20 day Realized Volatility down at around 8%, I’ve been hearing quite a bit from students and colleagues about long gamma positions – straddles in particular.

The idea is that volatility is so low that options are under-priced and should be purchased in bulk to profit from the impending price explosion.

Without necessarily arguing for or against that position, what follows are some thoughts on what I believe to be very basic options strategy.

The purpose of the straddle is to profit from either a gain in Implied Volatility or Realized Volatility (ie: a sudden change price movement). Since most beginning traders buy straddles in the hope of cashing in on an unforeseen breakout, it makes sense to begin with a quick discussion on realized (historical) volatility.

Watch: How a straddle option strategy works

Understanding realized volatility

In purchasing the straddle, the trader is essentially expressing a view that realized volatility (again, the variance in price movement) will see a remarkable increase. In other words, price is going to move either up or down big time relatively soon.

This does not necessarily indicate that the trader believes realized volatility is low. Realized volatility may in fact be hitting all time highs, but for whatever reason the trader sees it rising further (or at the very least, maintaining elevated levels).

But the point here is that no matter what bias the trader has in regards to implied volatility (more on that later), the trader is anticipating that price will move.

A little caveat here.

The straddle buyer can profit very well even if the typically calculated (close to close) Realized Volatility equals zero. In an exaggerated illustration, a stock that closed yesterday’s session at $10, but this morning opens at $30 before dropping down to close again at $10 will produce a Realized Volatility value of zero, while giving the trader ample opportunity to scalp or take profits intra-day.

What I’m getting at here is that the calculated value of the realized volatility indicator on your trading platform is not as important as the actual price movement.

Understanding Implied Volatility

On the other of the coin, straddle buyers that are perhaps more sophisticated anticipate that implied volatility will rise. Let me simplify that for a second.

If all the factors that go into the pricing of an option remain the same – meaning the underlying price, time to expiration and interest rates are completely frozen– the trader wants demand for the options that make up his straddle to increase after he buys them. If the straddle was a baseball card or a comic book or vinyl record or something along those lines, the trader wants to have purchased the thing when nobody cared about it and then sell it (or scalp it) when there aren’t enough of them to go around.

All this is seen in the implied volatility of the option price. In this respect, an option’s IV is a measure of its demand.

If a trader finds options priced at 20% volatility that he believes should be priced at 30%, then those options are perhaps a buy. Let’s take that a step further. This does not mean that an option that was priced at 30% two days ago and 25% yesterday is a deal today at 20%.

Just like a stock that is shedding price in a hurry, this option could very well be on its way to worthless. But if the trader’s outlook—be it based on reading the tape, technical analysis, the tendency for volatility to mean revert, an upcoming event, whatever—sees a 20% IV option as undervalued, then that certainly makes it worth purchasing.

It doesn’t matter if the option’s IV is cheap compared to where it has been trading, or if it is priced at a peak IV. What matters is how much more it will climb after it is purchased.

Now the truth is that we all know implied volatility tends to be mean reverting and so when we see IV dropping to unseen levels that may very well be the reason that causes up to buy straddles. No doubt this is something that we all do.

However, we need to be cognizant that falling volatility can always be on its way to establishing a new, lower mean. In the case of the most commonly watched IV value—the VIX—it is often easier to recognize volatility spikes than it is troughs.

Are Straddles the Best Trade?

The straddle is the most levered and the easiest to comprehend of the three basic long gamma position structures (the other two being the Strangle and the Backspread, or 1 by 2). Since this trade includes the purchase of at-the-money options, when initiating a position with roughly 30 days to expiration, one can easily use the typical platform’s Implied Volatility indicator as a proxy for the position’s IV.

There is a common tendency to oversimplify strategies. Perhaps it is easier to back-test, or incorporate into a systematic strategy, or just easier to teach a trade like a straddle than its derivatives. But when it comes to long gamma positions, the straddle is not the only position out there.

Before jumping right into a straddle when IV is cheap, think for a few minutes about your price outlook. If price looks as if it might sit still, the straddle will likely depreciate from theta decay faster than rising IV can help it—if indeed, you were right about IV in the first place.

In these cases, one might look to strangles or back spreads to offset some theta decay at the sacrifice of gamma.

Compare straddle and ratio back spread – Which is better?

The structure of the trade is going to depend more on the individual situation – what is happening with the IV’s of the different strikes involved – rather than the benefits of one position over another.

At times, the 1 by 2 is certainly a better trade than the straddle, while at other times it is preferred that the leverage of the straddle over the protection of the 1 by 2.

Other times, it is better to construct a synthetic backspread with the purchase of the straddle and the sale of an OTM call or put. That type of trade allows one to hedge off some of the theta risk, should price not make a move when anticipated, but it can still be easily managed if price does make a move.

Sometimes you can do these with OTM put or call spreads instead of the short put if conditions warrant. The bottom line being that it is all about what I anticipate the IV’s of the particular options to do. Those expectations depend largely on what that volatility surface looks like.