Volatility trading is founded on a high-probability strategic approach to the financial marketplace.
Options essentially represent an insurance market for investors and traders.
Consider for a moment the immense market for auto insurance. Now imagine how much premium customers have paid to auto insurance companies compared to the amount that has been paid out in claims.
There's clearly a reason that insurance companies can afford to purchase commercials during the Super Bowl.
A recent episode of Market Measures helps reinforce why selling options premium has historically been so attractive.
The focus of this episode is a well-known spread in the options trading universe known as a "straddle." A straddle involves the at-the-money (ATM) call and put. When both of these options are sold, the trader has initiated a "short straddle," and when both are purchased it is a "long straddle."
Estimating the breakeven price of a straddle is relatively simple. For example, if a trader sells a straddle for $10 in a $100 stock, then the trader will break even if the stock moves to $90 or $110 before expiration.
The ultimate profit or loss may be slightly affected by hedging adjustments, but generally speaking, the trader will profit between $90.01 and 109.99, and lose outside $90 and $110.
Breakevens for a straddle may also be expressed in percent terms. Given that the straddle price is $10, and the hypothetical stock trades for $100, then a trader selling this spread has effectively sold a 10% move ($10/$100 = 10%) over the duration of the contract.
If the stock moves less than 10% the position will be profitable, and if it moves more than 10% it will lose (note: hedging adjustments may also affect the ultimate profit or loss of the position).
To help better understand the performance of straddles in recent history, the Market Measures team backtested straddles in the SPY dating back to 2005. They focused on the performance of short straddles constructed using 50 delta calls and 50 delta puts, while managing these positions at 25% of maximum profit.
The results of the study, as pictured below, showed that on average the actual SPY straddle move as a percent of the expected move was only 63%.
These results indicate that on average SPY straddles were roughly 37% overpriced relative to the actual observed movement in SPY over the period of time examined.
Certainly, it shouldn't come as a great surprise that options premium in the financial marketplace tends to be overpriced, just as it is in the auto insurance market.
The information above also provides further context on why the potential for increased profits exits when volatility is rising or elevated, as outlined in this recent blog post.
For the best possible understanding of this material we hope you'll take the time to review the entire episode of Market Measures focusing on straddle premiums and expected moves when your schedule allows.
If you have any questions or comments, we also encourage you to reach out at firstname.lastname@example.org.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.