The Option Workshop

We focus on vertical spreads and risk equivalent structured positions - specializing in trade construction and risk management based on technical analysis, volatility surface and order flow.

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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. 

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 vol is low.  Realized vol 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 vol indicator on your trading platform is not as important as the actual price movement. 

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 isn’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 backspreads to offset some theta decay at the sacrifice of gamma. 

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Credit Spread Adjustments: Delta Hedging with Stock

One of the most effective ways to adjust a broken out-of-the-money vertical spread is with stock.  So many of us in the retail world—having been introduced to the flexibility and/ or leverage of options—seem hotly opposed to taking a position in an underlying stock, ETF or future.  Many of us would rather torment a simple vertical spread with layer upon layer of complicated adjustments, so that what started out as a hands-off strategy becomes a position that must be constantly tweaked—the original thesis for the trade reduced to a footnote.

The Decision to Adjust

Often the biggest risk to a credit spread is price:  a trader establishes a position and price woefully moves in the complete opposite direction than anticipated.  When trading out-of-the-money credit spreads, the general assumption is that implied volatility will decline (either overall or at a particular strike) and price will either move in a particular direction or remain in a perceived range.  Both scenarios result in a decay of premium and allow the trader to buy back the spread at a cheaper price than originally sold.  In the case of a bull put spread, the trader is neutral-bullish on price and bearish on volatility.  If that outlook proves incorrect, often the best adjustment is simply to admit being wrong and take losses.  But if the original thesis still holds water when the trade is under pressure, an adjustment can help manage risk while waiting for price and volatility to perform as anticipated.

Delta Hedging

The trick with making adjustments is to do so without completely sacrificing the original rationale for the trade.  The common adjustment of buying an out-of-the-money put is usually counter to the credit spread’s purpose because the put has negative theta (it decays) and positive vega (it profits from an increase in IV).  So if price does not continue south after the put purchase, the adjustment becomes a liability as it bleeds value (not to mention any complications from changes in vertical skew or if buying a different month, changing term structure).

Stock on the other hand, has no gamma; no vega; and no theta.  So the trader that shorts stock to protect a bull spread does not disrupt the spread’s rate of decay or volatility outlook.  And unlike a put, the deltas of a short stock position do not change with time, volatility or price.  An underlying stock position is “Delta” in the purest form.

For those new to this, allow me to explain.  Let’s say our credit spread is short ten 30 delta puts and long ten 20 delta puts.  We can add these together to get the delta of our overall position:  10 contracts  x (-30 + 20) = 100.  What this means is that the spread will lose $100 for every dollar the stock moves against it (ignoring gamma, theta and vega).  This is the primary definition of delta: the rate of change for every dollar movement in the underlying.  An underlying stock position is long one delta per share.  Our credit spread, being long 100 deltas is the rough equivalent of being long 100 shares of stock.

For the sake of argument, let’s say that our perception of risk, for whatever reason (be it emotional, strategy related or whatever) tells us that our position cannot withstand losing $100 per point of underlying movement.   We can reduce these deltas by shorting the stock.  How many shares we short will depend on our strategy and the level of risk.  For this illustration, let’s say our strategy demands we reduce our price risk to losses of $50 for every point in the underlying.  In this case, we would short 50 shares of stock (this can be done on margin in most accounts) and thereby reduce the overall position delta to 50.

Because this adjustment has no effect on gamma, theta or vega, the original credit spread’s potential to produce income from time decay and declining volatility is unimpeded.  The hedge allows the trader to return to a neutral-bullish bias, as he’d unwittingly become a hopeless bull when the position was threatened.  In fact, if the underlying remains range bound below the adjustment point, both the credit spread and the hedge can profit.

The Whipsaw

Some drawbacks are evident, the most obvious being the whipsaw.  Since trading stock is pure delta, it makes or loses money on a dollar for dollar basis.  Option traders are sometimes not used to that—it is akin to trading the deepest in-the-money option possible without the huge bid/ask spread.  However with stock, traders are not bound to hundred-lot contracts.  The trader can purchase or short the exact number of deltas required.

No Gamma

Another point that can’t be ignored is that the lack of gamma.  If price continues to move against the position or time ticks away, the vertical spread will pick up additional deltas that are not hedged by the long stock.  Since the underlying position is dynamic and the hedge is not, the trade may require additional hedging.

When to Exit the Hedge

One thing that should be very clear is that it that the desired outcome of the delta hedge by itself is a loss.  The trader expects gains from the larger underlying credit spread to outweigh the losses of the hedge.  Scenarios where the credit spread and the delta hedge both profit should be considered outliers rather than the goal of this particular adjustment.  With this in mind, it is wise to apply a budget to the hedge.  Commonly, this is 10-20% of the credit spread’s maximum profit.  In the case of the bull spread with the short stock hedge, one would remove the hedge when it incurred losses of that amount or when it is clear the hedge is no longer needed—whichever comes first.  This means a trader cannot wait until too deep in the hole to hedge the trade because a reversal in price will force him to remove the hedge while the risk is still high, or lure him into leaving the hedge on too long; diminishing the already limited returns of the credit spread.  The late hedger is vulnerable to whipsaws as price triggers him to remove and re-hedge with the danger of repeating the whole process over again.

Hedging Profitable Positions

While credit spreads in trouble certainly benefit from this type of adjustment, I’ve also found it useful for positions nearing a profit target with suspicious underlying price charts.  Stocks that are primed for a pullback or a bounce that may force the spread into an extended holding period—or worse, turn a winner into a loser—can be neutralized with stock to protect profits on the reversal.

Other Adjustments

Like any type of trade or adjustment, there is no single source solution for every situation.  What makes one adjustment better than another will always be dependent on the trader’s outlook, the perceived edges in the price chart and volatility surface and the trader’s own sense of comfort and expression.  The long put that I discounted at the beginning of this article is in fact, at times a wonderful hedge (see Vanna and the Put Explosion).  But for the trader looking to hedge a credit spread without disrupting the original outlooks of price, volatility and time, hedging with stock is a simple, easy to manage adjustment.

Trading Vertical Spreads with Edge

While I believe the most important element of position management begins with an intelligent entry, adjustments are often necessary and when done correctly, can significantly reduce risk while increasing the probability of profit.  In our upcoming course, tentatively titled “Trading Vertical Spreads with Edge,” we will discuss various adjustment strategies to fix broken trades.  The course will consist of roughly two months of live webinars and will be offered at a minimum cost.  I anticipate being able to offer this course in another month or so.  To be notified when this is available, send an email to [email protected].  Your email will never be shared elsewhere and you will never receive spam from me.  To those of you who have already notified me:  thank you.  I apologize for the wait.  I have a growing list and will be notifying you all as soon as everything is ready.