The Straddle is Pure Volatility

The Straddle is Pure Volatility

Given all that is going on in the world I am surprised at how low implied volatility is now. Fed today, triple witching Friday, continuing world political unrest, market close to all time highs (despite today’s small pullback), all reasons to think a large and unpredictable market move can happen at any moment.

For that reason, I want to talk about the purest volatility options trade there is. The at the money straddle. A straddle is being both long or short the call and put with the same strike price. If you own the straddle you want the underlying asset to move more than you paid for it and if you are short it you want as little movement as possible. The straddle price  in its collective wisdom of supply vs demand shows what the market thinks the trading range will be during the lifetime of the option.
For instance, let’s look at the SPY October at the money straddle. The 170 straddle is closest to being at the money and is trading at 4.60  (1.70 in the call, 2.90 in the put). This means that the market believes the trading range until the October expiration will be 165.40 to 174.60 (translating to 1654 to 1756 in the S&P 500). We call these prices the measured move targets.

Two factors aside from a move in the underlying asset will affect the straddle price. Time and implied volatility. The straddle decays with time and every day nothing happens the straddle will get cheaper. If implied volatility goes up the straddle will widen in price as the measured move targets get farther apart. This means that the straddle is not an up/down directional play, it is a play purely based on movement.

Keep in mind that selling a straddle is riskier than buying it. You cannot lose more than you pay for it but the seller has potentially unlimited losses. Buying the straddle is by no means a safe trade, however, particularly in times of high implied volatility (unlike now). Volatility can collapse like a bad souffle, taking the straddle with it. Time decay also counts when the market is closed, such as over weekends and holidays.

In short, I believe the straddle is best used as an indicator of what the market thinks the measured move targets are rather than as a good risk vs reward trading strategy.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

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