Introduction
Directionally neutral trading strategies are becoming increasingly popular among options traders. These strategies are based on the volatility of an underlying stock, rather than the price of the stock itself. With these strategies, traders can capitalize on the price movements of stocks without having to predict their direction accurately. In this article, we will discuss several different volatility trading strategies and explore how they are used by options traders.
The Straddle
A straddle involves simultaneously buying both a call and put option at the same strike price and expiration date, with the goal of profiting from increased volatility – either implied or realized. The main advantage of an options straddle is that it allows traders to benefit from volatility without having to predict which direction the underlying asset will move. With this strategy, traders can profit if the underlying asset moves significantly up or down, regardless of their expectations about its future performance.
Greeks of The Straddle
Because options are convex products, there are a lot of factors that contribute to changes in their prices. Options traders call these factors “The Greeks.” They can describe the risks of any options position. The main Greeks that traders typically use are delta, gamma, vega, and theta.
Delta
A straddle is a directionally neutral strategy. If a trader buys at-the-money (ATM) options, a straddle should have nearly no delta exposure at the beginning of the trade.
Gamma
A straddle is long gamma. This means the options’ delta will change favorably when the stock price fluctuates. While the at-the-money straddle is directionally neutral initially, the straddle will gain delta when the stock rises and lose delta when the stock falls.
When stock prices increase, the (formerly) ATM call option will now be in-the-money (ITM) and have a lot of positive delta. Conversely, the put option is now OTM – while it still has a negative delta, it should be closer to 0 after the stock increases. For example, an ATM straddle involves a 50 delta call and a -50 delta put, resulting in a net delta of 0. When the stock price rises, these may become 75 delta calls and -25 delta puts. At this point, the straddle will have a net delta of 50. This is important because the straddle will now profit from further increases in the stock price despite being initially neutral to the stock’s direction.
Gamma is the most important greek to be mindful of when trading straddles, as it’s the primary driver of the strategy’s PnL.
Theta
A straddle is short theta. This means that the option’s value will decrease over time, if the stock price or implied volatility remains the same.
The value of an ATM straddle is purely extrinsic; if the stock remains at the strike price until expiration, the straddle will be worth nothing.
Theta can be thought of as a payment for access to gamma. When traders buy a straddle, they pay for theta but benefit from any potential price movements in either direction. In this sense, it is similar to paying rent for a place to live – it’s worth it if you get the features and benefits you’re looking for. As such, Theta isn’t necessarily good or bad; it’s simply a trade-off you must make when buying options.
Vega
A straddle is long vega. This means the straddle will benefit from rising implied volatility. As implied volatility rises, both options increase in value. Implied volatility is the market’s consensus on future stock volatility. Volatility is great for long options (straddles included) because they give the buyer a larger chance of profiting. As such, demand and options prices will increase when the market’s forecast of future volatility increases.
When To Trade Straddles
Straddles are excellent structures for volatility trades. When a trader believes implied volatility is too high or too low, they can buy or sell the straddle to capitalize on the mispricing.
When implied volatility is too low, traders can buy a straddle, expecting to profit from vega as implied volatility rises or gamma when the stock starts making large moves. However, the option buyer will have to pay theta if they hold this position.
When implied volatility is too high, traders can sell the straddle, expecting to profit from falling implied volatility or time decay. However, since they are short gamma, they have to be wary of large moves in the stock, which could seriously hurt their position.
Example Straddle Trade
Options tend to be overpriced before earnings announcements. This is because there’s naturally a lot of demand for options at this time; many traders want to either speculate on the stock or hedge their positions with options. However, nobody really wants to sell options – it’s scary when the stock can move 10% overnight.
This supply/demand imbalance leads to straddles being too expensive – implied volatility is too high, and traders are paying too much extrinsic value. While the stock might move a little, this gamma profit is not enough to offset the drop in IV (IV crush) and the time decay that occurs the day after.
This is why selling straddles the day before earnings announcements are profitable.
The Calendar
On the surface, calendar spreads seem to be simply a bet on rising implied volatility and low realized volatility. While this is true, calendars are much more complex because they involve options for different expirations. Calendar spreads are a trade that sells short-term volatility while buying longer-term volatility – also known as a forward volatility trade.
The Calendar Greeks
Delta
Like the straddle, the calendar is a directionally neutral strategy. If ATM options are traded, the calendar is purely a volatility trade.
Gamma
Because the calendar sells a short-term option and buys a long-term option, the calendar is short gamma. This is because delta values of shorter-term options tend to react more as the time to expiration is shorter – to the point where 0 DTE options can flip from 0 to 100 delta as the stock moves several cents in and out of the money. Stock movement affects longer-term options less; their delta values change less.
Theta
Because the calendar is short gamma, it is also long theta. We collect more in theta from our short-term option than we pay for our long-term option because the short-term option has more gamma exposure.
Vega
The calendar spread is “long vega.” However, this is extremely misleading for calendar spreads because implied volatility moves differently across expirations. While it is true that a calendar spread would profit if the implied volatility of both options increased the same amount, this rarely happens in practice because the implied volatilities are for different time frames.
If the market suddenly expects a catalyst in the near future, short-term implied volatility typically increases much more than longer-term volatility. This is because the market expects elevated volatility in the short term but less volatility in the long term. As a result, calendar spreads may not profit even though they are “long vega” – the implied volatility of the short-term option we sold increases more than the IV of the long-term option we bought.
On the flip side, if the market expects increased volatility after the expiration of the short option, the long-term option we purchased will increase in value, but the short-term option we sold will remain unchanged.
Calendar spreads only profit from implied volatility changes if longer-term expectations of volatility change. When both implied volatilities change by a similar amount, the calendar spreads profits because the longer-term option has a greater positive vega.
When to Trade Calendars
Calendar spreads are excellent when trading short-term volatility against long-term volatility. For example, they can profit from future events that haven’t been priced in: our long option will increase in value while our short is unaffected. Calendars can also profit in situations where the market expects too much short-term volatility and not enough long-term volatility. In this situation, the short option can decrease in value while the long option increases!
Example Calendar Trade
Research suggests buying options up to 10 days before the earnings announcement and selling right before the event is profitable. This is because options traders tend to underestimate the demand for options during earnings. However, while future implied volatility may be too cheap, IV is still expensive for the period before earnings. By buying a calendar, traders can sell the options expiring before the earnings call and buy the options expiring after. This allows the trader to capitalize on the increase in the IV over the earnings period while having an offsetting position selling volatility before the earnings period.
Conclusion
Straddles and calendars are two powerful volatility trading strategies. Straddles allow traders to profit from changes in implied and realized volatilities. On the other hand, calendars can bet on expectations of future catalysts and trade differences between short-term and long-term volatility. With these tools at their disposal, volatility traders can choose to trade either the absolute levels of implied volatility or the relative levels between expirations.