Strangles, straddles and butterflies

[doctorj]

Overall straddles are a loser if applied indiscriminantly. A good winner though if done properly.

Apologies for digging up an old post wayne, I'm just curious what you mean by "indiscriminantly".

My interest in straddles has been piqued by a book on probability, psychology and randomness. The author claims that people tend to overvalue current information and undervalue the black swan risk.
The book isn't on trading, but is written by a trader. Aside from being a prick, he's pretty strong on his views and has got me thinking about options. But for a few units back in Uni, my experience with options is almost nil, so I'm interested in your feedback/experience on his strategy (follows).

Reading between the lines, I'm guessing he's primarily trading a long straddle (probably a fair way out of the money too) in circumstances where IV is relatively low. I understand it's likely to lose money far more often than not, but what's your gut feel on the prospect for a strategy like this to have a positive expectency? I doubt he's interested in trading breakouts, but more hoping to catch outliers.

To be honest, I'm not sure if I'm even asking the right question, so thanks for your patience.

 

[wayneL]

Apologies for digging up an old post wayne, I'm just curious what you mean by "indiscriminantly".

Doc,

If you just bought straddles every month, opening the next one as the last one expires, on a range of instruments/stocks, it would most certainly in the long term be a loser.

Why? Think about option pricing and what it attempts to achieve, bearing in mind there are two sides to every trade. If option pricing were totally efficient, straddles/strangles would essentially break even, whether long or short, again in the long term. However because of contest risk (bid ask spread and commish) they both become a loser.

With these strategies it is up to the trader to exploit inefficiencies and or pick favourable conditions for profit, scalp gamma/hedge delta.

My interest in straddles has been piqued by a book on probability, psychology and randomness. The author claims that people tend to overvalue current information and undervalue the black swan risk.
The book isn't on trading, but is written by a trader. Aside from being a prick, he's pretty strong on his views and has got me thinking about options. But for a few units back in Uni, my experience with options is almost nil, so I'm interested in your feedback/experience on his strategy (follows).

Reading between the lines, I'm guessing he's primarily trading a long straddle (probably a fair way out of the money too) in circumstances where IV is relatively low. I understand it's likely to lose money far more often than not, but what's your gut feel on the prospect for a strategy like this to have a positive expectency? I doubt he's interested in trading breakouts, but more hoping to catch outliers.

To be honest, I'm not sure if I'm even asking the right question, so thanks for your patience.

What the author is proposing (I presume it's Mr T?) is that WTFOTM (way the f*** out of the money) options are inefficiently priced and that the occasional black swan will hand the trader a handsome profit.

I'm not a mathemetician and don't have the skills to prove or disprove that, but it doesn't sound right to me in the real world of trading. It's a bit like placing your chips on 0 for every bet; a 1/37 chance, but you could be a waiting a heeeeeellll of along time for it to come up. Meanwhile your capital is being whittled away.

In the real world, we don't know the probabilities or the payoff of such a strategy... that's hard enough to calculate with more conventional strategies

If it is Mr T, I think he's talking WTFOTM puts rather than strangles, as the black swan lurks to the downside only in stock indices, but don't know for sure.

Looking at the psychology of such a strategy, it's one hell of a long time between drinks. Could you trade this from 2003 till early 2008 without a substantial profit? Not this little black duck.

Caveat: I haven't read the book and could have the wrong end of the stick.

 

[doctorj]

Thanks for that Wayne. I'll have to absorb your comments.

You nailed the author in one. I had considered the WTFOTM puts too, but I had assumed the premise he's working on was equally applicable on the upside and downside.

As for your comment about a straddle being a losing strategy, the way I'm interpretting what you've said is that options are always priced efficiently - wouldn't that make all option strategies losing? Are you then suggesting that the nature options lends itself to having a toolbox of sorts you selectively apply, as opposed to a more mechanical strategy?

 

[wayneL]

Thanks for that Wayne. I'll have to absorb your comments.

You nailed the author in one. I had considered the WTFOTM puts too, but I had assumed the premise he's working on was equally applicable on the upside and downside.

As for your comment about a straddle being a losing strategy, the way I'm interpretting what you've said is that options are always priced efficiently - wouldn't that make all option strategies losing? Are you then suggesting that the nature options lends itself to having a toolbox of sorts you selectively apply, as opposed to a more mechanical strategy?

No, not that they are always priced efficiently. The inefficiency is that a volatility projection is collectively made by the market. The market won't always get that right... but overall, the inefficiencies will cancel each other out if you trade every concurrent series.

Thus the goal of the long straddle trader is either.

1/ get a big move one way or the other, big enough to overcome the double time decay and any volatility crush if present.

2/ Be long vega i.e. you are expecting a rise in option volatility (and movement)

3/ To scalp gamma

All three require some volatility projection skills and an understanding of what's happening with the greeks, in order to optimize the timing of entry/exit and which expiry to use etc.

There are setups that when they turn up, it's pretty hard to lose. Other setups that are almost certain losers.

Eg. If a long dated straddle is put on with option volatility at relative highs, you need a very large move for it to pay even considering the time the trader has given himself. Why? Vega risk and very low gamma.

If it goes quiet on you or even doesn't realize the volatility priced into the option, there will be a large loss (relative to potential reward).

***

What I'm really trying to say is that it's not an each way bet as promoted by the option education clowns. You have to know which of the greeks you are trading and which of the greeks are your risks, and pick the time when these are most suitable for what you have in mind.

 

[shooter]

Hi WayneL

I've been paper trading on U.S. options. Since I'm not good at analyzing share movement. My main strategy has been either strangle or straddle type. I do realize that on top of all those criteria, how I buy call and put makes a significant difference on profit profile using Black Scholes model. Standard 1 call at X and 1 put at Y does not usually neutralize the delta unless (DeltaC = -DeltaP), and this makes the width of breaking even points to be greater than that of properly delta neutralized strangle or straddle in the early part of the game (first few weeks) and as a result, requires larger movemet of the underlying share price in order to profit.

I appreiciate the effect of volatility. In some of my positions, both call and put made money because of the increasing implied volatility. In this case, strangle and straddle type make more money than just a single long put or call. The vega risk is a lot higher for straddle type but also return can be higher when IV goes up. It is now very important for me to acquire a volatility projection skill. Is there any recommended reading material I should cover for this??? Please let me know, I much appreciate it.

I ve been working on a closing strategy for this type of strategy. But it is kind of tricky. Also I m working on a strangle strategy that starts off with delta neutral and as the time passes by ( after 2 or 3 weeks), the loss region shifts away from the original share price so that it serves as a neutral strategy in the beginning and if it is all quiet for awhile the shift in loss region may help the share price to hit the profit region.

Thanks for your time

 

[wayneL]

Hi shooter,

These are really good questions.

Hi WayneL

I've been paper trading on U.S. options. Since I'm not good at analyzing share movement. My main strategy has been either strangle or straddle type. I do realize that on top of all those criteria, how I buy call and put makes a significant difference on profit profile using Black Scholes model. Standard 1 call at X and 1 put at Y does not usually neutralize the delta unless (DeltaC = -DeltaP), and this makes the width of breaking even points to be greater than that of properly delta neutralized strangle or straddle in the early part of the game (first few weeks) and as a result, requires larger movemet of the underlying share price in order to profit.

Great points, and really exposes the nonsense of the options spruiker's usual schpiel on straddles/strangles. I only like them when all the planets line up correctly, then I rarely lose. But indiscriminate straddle buying is an almost certain loser over the long term.
Re delta neutral. Yep, you do want to truly neutral. You can do this a couple of ways.

1/ Only place the straddle on when it is neutral. In stocks, that is slightly below the strike. This is due to the cost of carry priced in to stock options.

2/ Use a synthetic straddle (using calls and short shares or visa versa) , creating delta neutral by adjusting the number of shares.

Other things to be aware of. Straddles/are a trade off of greeks. More time means less gamma, more movement needed to manufacture delta, more vega, less theta. Less time means more gamma, less movement to manufacture delta, less vega, but more theta.

Where you go in this regard depend are your view and exit/hedging strategy.

I appreiciate the effect of volatility. In some of my positions, both call and put made money because of the increasing implied volatility. In this case, strangle and straddle type make more money than just a single long put or call. The vega risk is a lot higher for straddle type but also return can be higher when IV goes up. It is now very important for me to acquire a volatility projection skill. Is there any recommended reading material I should cover for this??? Please let me know, I much appreciate it.

I will eventually cover it in my site, but that's a way off yet. Sheldon Natenburg's Volatility and Pricing is probably the best though.

I'll say one thing, some of the standard dogmas are rubbish. The best thing IMO is the observation. Things to watch:

The volatility prediction capabilities of Implied volatility.
The cycling of volatility
The behaviour of IV approaching announcements; and immediatly afterwardss

I ve been working on a closing strategy for this type of strategy. But it is kind of tricky. Also I m working on a strangle strategy that starts off with delta neutral and as the time passes by ( after 2 or 3 weeks), the loss region shifts away from the original share price so that it serves as a neutral strategy in the beginning and if it is all quiet for awhile the shift in loss region may help the share price to hit the profit region.

Thanks for your time

Don't quite know what you mean in the second part of this paragraph.

 

[shooter]

Hi WayneL

Thanks for the reply

1/ Only place the straddle on when it is neutral. In stocks, that is slightly below the strike. This is due to the cost of carry priced in to stock options.

I usually do this;
Suppose Nc and Np are the number of call and put options respectively, then they have to satisfy the following equation

Nc/Np= -DeltaP/DeltaC

If this is satisfied, the total delta for the strangle or straddle position is Nc*DeltaC + Np*DeltaP = 0 (* means times). In reality you can't make it exactly zero (due to the fact that Nc and Np are integers) but close to it.

2/ Use a synthetic straddle (using calls and short shares or visa versa) , creating delta neutral by adjusting the number of shares.

I like this strategy too. I only have tried with a long put and long stock. Only thing that I don't like about it, is the low leverage and small gamma. But theta and vega are smaller than straddle or strangle so I feel more comfortable openning the position longer. I prefer to use this after strangle or straddle makes money and lock the profit. Only the problem is when the current total delta is positive then I have to short sell shares and some securities I can't short sell them (it happened to me on optionsXpress virtual trading). Once it is locked, then I make an iteration of the process of waiting for the share price to move then lock the profit.

Other things to be aware of. Straddles/are a trade off of greeks. More time means less gamma, more movement needed to manufacture delta, more vega, less theta. Less time means more gamma, less movement to manufacture delta, less vega, but more theta.

A great point!

Don't quite know what you mean in the second part of this paragraph.

Sorry for not making myself clear. It is much easier to explain with the theoretical plots I made, but it seems that I can only post pics with a URL address and currently unable to post them. I need find the way.

Cheers for the good advice

 

[wayneL]

I like this strategy too. I only have tried with a long put and long stock. Only thing that I don't like about it, is the low leverage and small gamma. But theta and vega are smaller than straddle or strangle so I feel more comfortable openning the postion longer. I prefer to use this after strangle or straddle makes money and lock the profit. Only the problem is when the current total delta is positive then I have to short sell shares and some securities I can't short sell them (it happened to me on optionsXpress virtual trading). Once it is locked, then I make an iteration of the process of waiting for the share price to move then lock the profit.

So you are gamma scalping, if I understand you correctly? Cool. The stock in the synthetic will help markedly.

The synthetic straddle will have identical greeks to the natural.

eg 5 x call + 5 x put

is synthetically equivalent to

500 X STOCK + 10 x put

Regards to the margin required, if you're on portfolio margining, margin will be identical. If not however, you can create a hybrid natural/synthetic to soften the blow.

For example

200 x STOCK + 3 x call + 7 x put will be the synthetic equivalent of the above.

This will leave you enough shares to gamma scalp, while reducing margin compared to the "pure synthetic". Hows that for an oxymoron?

 

[VolTracker]

An alternative way to trade synthetics with greater leverage is to do the legs separately in an options a/c and a CFD a/c.

For example, instead of 50% margin in stocks with OX, you can get 95% on many ASX blue chips with Macquarie (still need a buffer for MTM vals).

Can be fiddly, with higher execution risk but worth considering especially with such high IV's currently.

 

[shooter]

Hahaha.. I didnt know it is called gamma scalping. I m still a newbie and I don't know many terminologies. I've been trying whatever the method that seem to work mathematically. Thanks WayneL. I ll investigate further on this technique.

 

[wayneL]

Hahaha.. I didnt know it is called gamma scalping. I m still a newbie and I don't know many terminologies. I've been trying whatever the method that seem to work mathematically. Thanks WayneL. I ll investigate further on this technique.

Ron Ianeri put together a good intro video. have a look here: http://www.options-university.com/Videos/GammaTrading/

Contains sales spiel, but a good video imo.

 

[shooter]

Ron Ianeri put together a good intro video. have a look here: http://www.options-university.com/Videos/GammaTrading/

Yeh it is a good introduction. The guy in the video sounds enthusiastic for the solid 30 min.

 

[sails]

Yeh it is a good introduction. The guy in the video sounds enthusiastic for the solid 30 min.

Yeah - the few times I have heard him, it's always the same. Full marks for being passionate about his subject!

Ron took a session on "Volatility and Options Pricing" on ThinkorSwim's free Wednesday trader lounge on 12th March, 2008. The archive is found on found on this page: http://www.thinkorswim.com/tos/displayPage.tos?webpage=onlineSeminar&displayFormat=hide

BTW Wayne - good stuff on your site and so well set out. Should really help budding option traders - will also follow it with interest

 

[wayneL]

Yeah - the few times I have heard him, it's always the same. Full marks for being passionate about his subject!

Ron took a session on "Volatility and Options Pricing" on ThinkorSwim's free Wednesday trader lounge on 12th March, 2008. The archive is found on found on this page: http://www.thinkorswim.com/tos/displayPage.tos?webpage=onlineSeminar&displayFormat=hide

BTW Wayne - good stuff on your site and so well set out. Should really help budding option traders - will also follow it with interest

Thanks sails. I'm relying on you to pick up any BS.

 

[sails]

Thanks sails. I'm relying on you to pick up any BS.

lol, definately not expecting any. Only ever found one mistake and, if I remember correctly, that was only due to one small imput missed in Hoadley... Wasn't even trying to check up - was only trying to understand the trade you had on!

 

[shooter]

I will eventually cover it in my site, but that's a way off yet. Sheldon Natenburg's Volatility and Pricing is probably the best though.

I forgot to ask. May I have a look at your site please? I am very interested!

 

[wayneL]

I forgot to ask. May I have a look at your site please? I am very interested!

Just click on the link in my sig. I'm still going through the basics, but any questions, ask here on ASF.

Cheers

 

[shooter]

Just click on the link in my sig. I'm still going through the basics, but any questions, ask here on ASF.

Cheers

Looks like a great effort put into the site. I am looking forward to a further development. Please let me know if there is anything I can do to help. Probably only thing I can provide is 3D plots of Black Scholes equation. I have a maths software to plot the pay off curve with respect to strike price and time progression. Also I can plot all the greeks with respect to any of the variables, share price, strike price, volatility, interest rate, etc. The profile of pay off and greeks can be described by words but it might be helpful for the visitors of the site to visualize it in 3D.

 

[wayneL]

Looks like a great effort put into the site. I am looking forward to a further development. Please let me know if there is anything I can do to help. Probably only thing I can provide is 3D plots of Black Scholes equation. I have a maths software to plot the pay off curve with respect to strike price and time progression. Also I can plot all the greeks with respect to any of the variables, share price, strike price, volatility, interest rate, etc. The profile of pay off and greeks can be described by words but it might be helpful for the visitors of the site to visualize it in 3D.

Yes that's exactly what I had planned as I get into the greeks etc. Thankyou for the offer, if I get into bother with images I'll certainly give you a yell.

Cheers