Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

Chapter 14. The Straddle and Strangle: The Risks and Rewards of Volatility-Sensitive Strategies

Traders and investors who trade straddles and strangles make these dicey choices because they believe that the volatility of the underlying asset does not correspond to the implied volatility embedded in the option price. When you buy or sell a strangle or straddle, you are on one level stating that the market is wrong, that the market is not correctly pricing the implied volatility of the options contracts involved. There is often substantial risk, however, in options strategies set up to exploit a perceived mispricing in the implied volatility of the underlying asset. The risk is that the asset could abruptly change after the straddle or strangle is in place.

Yet traders love to buy and sell volatility-sensitive options, even though these strategies typically carry significant risk. After placing these trades, two primary factors impact the value of the options:

1. The future volatility expected to prevail over the life of the options contract

2. How the share price of the underlying stock moves over time

You can create an options strategy sensitive to the volatility of the underlying stock but not particularly sensitive to price changes of that same asset. Likewise, you can form a strategy sensitive to the underlying price changes while being only minimally sensitive to its volatility. Finally, you can create a strategy that will provide you with a balance, so that you limit exposure to both ...