Last week I wrote about a situation where we believed that the price of an ETF (XLF) was likely to move quite a bit, but we were unsure of the direction; and we believed that the ETF’s Implied Volatility (IV) was likely to rise. I mentioned that we’d look at two alternative strategies that are often used in this situation.
Those two strategies are Straddles and Strangles. I did discuss straddles on their own a few weeks back, but today we’ll compare them to strangles. Each of these strategies makes intuitive sense if we expect a large move but don’t know the direction, because each involves buying both call and put options. The calls win if the price rises, with no upper limit, while their cost is finite. Likewise, the puts could win an (almost) unlimited amount if the price falls far enough, with a finite cost to buy them. So if either the puts or the calls can win enough to pay us back for both of them, Straddles or Strangles will be a winning position.
Not so intuitive to new traders is the effect of changing IV. Separately from the change in underlying price, an increase in IV would push upward on the price of both puts and calls. A decrease in IV would have the opposite effect. Notice that I said push upward on option prices. I did not say make option prices go up. This is because the push from increasing IV could be opposed by one or both of the other two forces that are constantly pushing on each option’s value – time and underlying price. An increase in IV alone will indeed push upward on all option prices. That push from IV may or may not be enough to make option prices actually rise, when netted with the other two forces.
The passage of time is eating away at the time value portion of every option’s value every day. This time decay is constantly pushing downward on the value of this position, and on both sides of it, at that. Since straddles usually involve buying at-the-money (ATM) options, and strangles usually involve buying out-of-the-money (OTM) options, all such positions consist of options that have no intrinsic value (no in-the-money [ITM] options). The entire price we pay for these positions consists of time value alone. And this time value is dropping constantly.
If time value is melting away by the minute, do we ever want to buy a position that is nothing but time value? In some cases, that is exactly what we do want. The situation where we strongly expect IV to rise is that case. When we buy time value, we are in effect buying IV. We are intentionally buying IV low, so that we can sell it high (after it rises). Note that this means that we have to sell our straddles/strangles long before expiration while they still have a lot of time value. These are not positions that we can hold until expiration.
With straddles and strangles, our challenge is to minimize the negative effect on our position of time decay. Fortunately, there is a way to do that. Remember that time decay is not linear. It starts out slowly when an option has a long time to expiration, and gets faster and faster as expiration approaches. If we buy our straddles/strangles when they have a long time to run, say 90 days or more, time decay will initially be hurting us very little. We should then plan to sell out the options before time decay really begins to bite (say at 60 days or more to go), even if our hoped-for price move and/or IV increase hasn’t happened by then. In this way, we have not exactly bought all that time value – we’ve just sort of rented it.
That’s the general idea behind straddles and strangles. Here are the effects of the various forces, as measured by the Greeks:
Underlying Price Movement (Delta) – Initially Neutral. Initially movement in either direction has a minimal impact on us. Calls win as puts lose and vice versa. We start out with roughly zero net deltas (Calls around +50 and Puts around -50 for straddles). But as soon as price moves at all, the position quickly changes its delta reading. We want a high and increasing delta – either positive or negative – as price moves – check.
Acceleration of position value change with underlying price change (Gamma) – Large Positive. This position has a high positive gamma. Although initial underlying price movement has little effect, the farther the underlying moves (in either direction), the more profit accrues. The winning side wins at an ever-increasing rate, while the losing side loses at an ever-decreasing rate. The higher the gamma, the greater this effect is. Both puts and calls have positive gamma, and the options that are ATM have the highest gamma. We are buying ATM or near-the-money options here, times two, so we will have a large positive gamma. In this situation, we want a high positive gamma – check.
Time decay (Theta) – Moderately Negative. We made it moderate by using distant expirations and planning to sell them long before expiration. If we attempted to use options in the last month of their life, we would have a highly negative theta, not just moderately negative. It would be nice if we could always have positive theta with every position, but that’s not possible. Any position that benefits from price movement (rather than from price standing still) will lose value over time. In Greeks terms, any position with positive gamma has negative theta. In this case, we’ve at least minimized the pain from time decay.
Changing Implied Volatility (Vega) – Highly Positive. We bought a lot of time value. Rising IV increases time value. That’s what we’re banking on here.
So how do the straddles and strangles differ? Which position would be the bigger winner if our expectations came true?
First, strangles are always cheaper. Straddles are done with ATM options, so we’re buying lots of time value. Strangles are done with options that are each at least one strike farther OTM then straddles, and therefore are cheaper. As of 12/14, the March straddle for XLF, with calls and puts at the 16 strike, was quoted at $1.20 ($.53 for the calls and $.67 for the puts). The strangle one strike further OTM (March 15 puts and March 17 Calls) was only $.48 ($.17 for the calls and $.31 for the puts).
Using option position modeling software (available in your option trading platform or from standalone option software providers), we can estimate how the straddles and strangles would perform in different scenarios (different combinations of price and volatility changes over time). We’ll dig into that in detail next time.
For now, here are some key observations.
– If volatility were unchanged, at our target prices of $15 on the downside or $17 on the upside, the Straddle would just about break even a month from now. The Strangle would lose between 8 and 14 cents at those prices. With constant volatility, if price also were unchanged at $16, the Straddle would lose 31% of its cost, while the strangle would lose 73%
– If XLF’s IV returns to 25%, where it was as recently as November 12, 2012, then at the January expiration the Straddle could not lose regardless of underlying price. At our $15 and $17 targets it would make 20% and 25%, respectively, on its cost. For the Strangle, on the other hand, with an IV of 25%, there would be a max loss of about 15% of its $.48 cost. At our $15 and $17 targets, the strangle would make 21% or 37%, respectively.
So, the bottom line is: the Strangle loses more (as a percentage) if nothing moves, and wins more (as a percentage) if our hoped-for changes happen. Which to use depends on just how confident we are in the expected changes.
For comments and questions on this article, contact me at firstname.lastname@example.org