Mini Chapter Nine
Option Market Strategies
While it’s hard to lay out watertight rules for structuring strategies (as markets can throw unimaginable circumstances) there are a few considerations to remember a) you would generally not buy deep in the money options b) you would not sell deep out of the money options cheap c) structure your trades keeping the gamma versus theta battle in mind – while short dated expiries bring gamma to your books, they also pose time decay risks that more than offset gamma hedging gains if realise vol remains below implied d) longer expiries have less gamma and more vega but more sensitive to discounting risks (rho) e) gamma gains more from higher realised vol than vega does.
Straddles
- A long straddle position would mean going long a put and a call at the same strike for the same expiry, typically at the money forward i.e. a zero net delta option as Delta of the call cancels out the delta of the put at inception.
- Gamma and Vega are therefore highest at the strike
- Option premium paid is twice as much as that for a simple call or a put at that strike
- Theta/time decay is also the highest at the money which is a cost for owning both gamma and vega (the relative presence of each depends on option expiry)
- The structure is widely traded in the inter-bank market as an expression of the price of both realised and implied volatility. In other words gamma is an exposure to realised volatility while vega is an exposure to implied volatility. The Straddle owner typically doesn’t bet on the direction of the underlying’s price movement hence doesn’t own any net delta.
- This trade would break even when the price movement in the underlying on any one side compensates for the total premium paid.
- A straddle owner could choose to run a delta-neutral position at all times by trading the same underlying stock. This process of delta adjustment would ideally generate profits (due to positive gamma i.e. buying lower and selling higher) to more than compensate for the premium paid if the realised volatility is higher than what was implied in the option price to begin with. If the realised vol is lesser than implied then the time decay (theta) would be higher than the money made by hedging the delta.
- Consider below graphical representations of the price and Greek profiles of a 110 straddle:
Graph 19 – Straddle price across Option expiries
Graph 20 – Straddle price across Implied Vols
Graph 21 – Straddle Delta across Option expiries
Graph 22 – Straddle Delta across Implied Vols
Graph 23 – Straddle Gamma across Option expiries
Graph 24 – Straddle Gamma across Implied Vols
Graph 25 – Vega profile of a Straddle across Implied Vols
- Strike to depict the vega profile above is taken at 110 to standardise with a call option’s vega profile in graph 13 of Mini Chapter 5. A pleasant comparison between the two graphs would suggest that vega of a straddle (at ATMF strike of course) is equivalent to 2x vega of any of the call or put option with the same strike.
- For all other strikes too the put call parity brings out the same conclusion i.e. the vega of a call and a put at the same strike and expiry is equal. Hence for > 0 delta straddles the vega amount would still be 2x the vega amount in either of the underlying vanilla options.
