Volatility
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Going Long Volatility

Alan Grigoletto
December 9, 2016
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Going Long Volatility

No on can accurately predict whether the worst is over or just pausing before stocks make another dramatic move lower. The Long Straddle can be used to take advantage in either outcome.

The Long Straddle is composed of a long call option and a long put option. Both options are at the closest At-The-Money-strike (ATM) of the same expiry. The goal is profit from any significant move in either direction. The position can also make money from an increase in implied volatility without a significant move from the underlying.

As there are two options being purchased, the combined expense sets a relatively high cost for the strategy to break even. The maximum loss is, however, limited to the combined premiums of the call and the put.

There are two break-even points:

The upside breakeven = Call strike price + premium paid.

The downside breakeven = Put strike price – premium paid.

Recall that the ATM strikes will naturally have greater premiums and a higher overall cost than Out-of-The- Money (OTM) strikes. The strategy of using OTM strikes is called a Strangle. Time decay from being long both options is the natural enemy of this strategy as is any decrease in implied volatility. The profit is unlimited to the upside and limited only on the downside of the underlying going to zero.

The timing for implementing this strategy is critical due to the time decay of two options. As discussed in an earlier piece, options see their steepest time decay 30 days prior to expiry. The investor has to have a very clear forecast for increasing volatility or a dramatic move of the underlying. Investors can get on the right footing by looking for opportunities where implied volatility is below historical averages, or several weeks prior to earnings or government reports that can affect the sentiment of a particular industry. The outcome tends to be most dramatic following these events.

Let’s look at an example:

XYZ stock is currently trading at C$39. The December 16 is expiry is four weeks out and the 40 Call is priced at C$.80 and the 40 Put is priced at C$1.60. The total cost for this position is C$2.40.

Stock Price at Expiration Long 1 December 16 expiry 40 Call P/L at Expiration Long 1 December 16 expiry 40 Put P/L at Expiration Total P/L at Expiration
$55 $14.20 ($1.60) $12.60
$50 $9.20 ($1.60) $7.60
$45 $4.20 ($1.60) $2.60
$40 ($.80) ($1.60) ($2.40)
$35 ($.80) $3.40 $2.60
$30 ($.80) $8.40 $7.60
$25 ($.80) $13.40 $12.60
$20 ($.80) $18.40 $17.60

The table above demonstrates that the Long Straddle becomes profitable in either direction provided the movement of the underlying is dramatic enough to overcome the cost of the two premiums. The underlying at stand still will result in a loss for both Call and Put.

Final thoughts: There is no assignment risk for this strategy, however, in the event that the trade is held into expiry, the investor should have a contingency plan for auto exercise should either option finish In-The-Money (ITM).

Alan Grigoletto
Alan Grigoletto

CEO

Grigoletto Financial Consulting

Alan Grigoletto is CEO of Grigoletto Financial Consulting. He is a business development expert for elite individuals and financial groups. He has authored financial articles of interest for the Canadian exchanges, broker dealer and advisory communities as well as having written and published educational materials for audiences in U.S., Italy and Canada. In his prior role he served as Vice President of the Options Clearing Corporation and head of education for the Options Industry Council. Preceding OIC, Mr. Grigoletto served as the Senior Vice President of Business Development and Marketing for the Boston Options Exchange (BOX). Before his stint at BOX, Mr. Grigoletto was a founding partner at the investment advisory firm of Chicago Analytic Capital Management. He has more than 35 years of expertise in trading and investments as an options market maker, stock specialist, institutional trader, portfolio manager and educator. Mr. Grigoletto was formerly the portfolio manager for both the S&P 500 and MidCap 400 portfolios at Hull Transaction Services, a market-neutral arbitrage fund. He has considerable expertise in portfolio risk management as well as strong analytical skills in equity and equity-related (derivative) instruments. Mr. Grigoletto received his degree in Finance from the University of Miami and has served as Chairman of the STA Derivatives Committee. In addition, He is a steering committee member for the Futures Industry Association, a regular guest speaker at universities, the Securities Exchange Commission, CFTC, House Financial Services Committee and IRS.

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