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Options Theory: How to Make a Pure Volatility Bet Part 2

September 24, 2017

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Last week we kicked off our exploration of volatility trades with an emphasis on how to go long volatility. Such a tactic comes in handy when you’re willing to wager a stock will move more than expected. Today we look at the alternate scenario – what to do when you think a stock will move less than expected.

Let’s begin by restating the key takeaways from last week’s missive:

  • It’s possible to make a bet on how much the market will or won’t move using volatility trades.
  • The common characteristic among these trades is they start out delta neutral.
  • Traders anticipating the market will move more than expected go long volatility.
  • Traders anticipating the market will move less than expected go short volatility.

Suppose we have a stock trading for $100 and we think it’s not going to move very much. To exploit its neutral behavior we can enter a short volatility trade. To be more specific, it’s not that we don’t think the stock is going to move, rather, it’s that we think the stock will move less than expected.

One of the simplest strategies designed to profit from just such an outcome is the short strangle. This delta neutral trade consists of selling an out-of-the-money call and an out-of-the-money put. Let’s say we can sell the $105 call for $2 and the $95 put for $2. All told, we would receive a $4 credit. That means that as long as neither option is in-the-money by more than $4 at expiration, we will escape with a profit.

The upper breakeven, then, is $109 and the lower breakeven is $91. That means the market expects the stock could trade up or down $9 (remember the stock is at $100 at trade entry) between now and expiration. The reason we would be selling the 95/105 strangle is that we believe the stock will move less than that $9.

Here’s how I visualize the bet:

The yellow lines represent what the market expects, and the blue lines represent what I expect.

Since the range I anticipate is smaller than what the strangle is pricing in (i.e., what the market expects), I want to be a volatility seller. That is, I want to go short volatility!

To mirror last week’s discussion, let’s now turn to analyzing the trade from a greeks perspective. Once again we’ll focus on delta and vega.

Suppose the $105 call we sold carried a delta of 25 and the $95 put we sold carried a delta of -25. Since we sold the call the delta flips from positive to negative, so that side of the position will provide a -25 delta. And since we sold the put its delta flips from negative to positive, so that side of the strangle provides a +25 delta. Adding them together results in a net delta of zero.

That means whether the stock rises or falls $1 doesn’t matter since in both cases the gain from the call (put) will offset the loss from the put (call). At least initially. But while the delta is zero, the vega of the position will be negative. Maybe the call has a vega of -10 and the put has a vega of -10. To summarize, our short strangle has a delta of zero and a vega of -20. We are directionally neutral and short volatility!

Make sense?

The Superior Choice

Now that we understand that it is possible to make pure volatility bets you may be wondering which is better. Should we lean towards making long vol bets via strategies like long straddles? Or, should we focus more on making short vol bets via strategies like short strangles and iron condors?

My personal opinion and the one that is backed up by reams of historical data is to focus on short volatility strategies. That means I much prefer betting the market will move less than expected than betting it will move more than expected. I discuss the reasoning in great detail in the Cash Flow Condors Premium System but here’s the gist.

Investors consistently overestimate market movement. Fear of future uncertainty is almost always exaggerated. As a result, options are systematically overpriced, and those that orient themselves as net sellers have an edge. I would much rather be short perception and long reality than long perception and short reality.

Iron Condors are idea for generating CASH FLOW. Click on the image and get the Cash Flow Condors Premium Trading System right away!

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One Reply to “Options Theory: How to Make a Pure Volatility Bet Part 2”

  1. JacobAgbor says:

    Nice article, my favorite quote and life lesson… “I would much rather be short perception and long reality than long perception and short reality”. wow!

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