Vanilla options can be combined to create different payoffs. Some of these combinations are so common that the resultant structures have standardized names that are requested by clients or quoted in the interbank broker market.
For an FX derivatives trader, it is most important to understand how these combinations of long and short vanilla options impact the exposures in the trading position. Within this chapter, vega is the primary focus. If structures are traded to shorter maturities, the most important exposure will be gamma. As observed in Chapter 6; for vanilla options, gamma profiles and vega profiles have similar shapes but they evolve differently over time.
A straddle contains two vanilla options with identical contract details (same currency pair, buy/sell direction, notional, expiry, strike, and cut) except that one is a call and the other is a put.
Exhibit 8.1 shows the value at maturity of a long USD/JPY 100.00 straddle in notional N per leg:
Thanks to put–call parity, making a volatility price for a straddle is the same as making a volatility price for a single vanilla option in the combined notional with the ...