Options: Volatility Trading Part 2

Question 1

What are the basics of managing a long straddle position?

Answer 1

If the trade is motivated by expectations of positive Δσ, the the position must be closed before maturity once there has been an increase in the value of the two options.

Question 2

What is the potential problem of managing a long straddle position?

Answer 2

Negative Theta. If Δσ = 0, portfolio value will decrease naturally with time.

Question 3

What are the two consequnces of ngetive Theta on a long straddle position?

Answer 3

1. The timing with which the position is opened (and closed) is often important. (every day spent waiting has a cost in terms of Theta)
2. The maturity of the straddle (straddle with maturity of two months has a more positive Vega and a less negative Theta, while a straddle with maturity of 20 days has a less positive Vega and a more negative Theta; as a result very short maturities are often avoided for trades on Δσ)

Question 4

What is the danger of a short straddle position?

Answer 4

For the holder of a sholder straddle, theta effect is positive and deterministic; however, Gamma effect is negative and depends on the size of ΔP². The cost of waiting in this case comes from the Gamma effect.

This results in a big potential risk: sudden jump of both implied and actual volatility up results in combined losses from both Gamma and Vega.

Question 5

What is the VIX?

Answer 5

The VIX is the index of implied volatility of 30-day option on the S&P500. It is calculated by the Chicago Board Options Exchange based on a wide set of puts and calls with maturity just below and just above 30 days. The index is not tradeable, but futures and options on the VIX are tradeable.

(There is a similar VSTOXX index on EuroStoxx50)

Question 6

What does a futures VIX trade with a price of 25 mean mean?

Answer 6

A VIX futures price of 25 corresponds to a 30-day implied volatility of 25%, and the multiple is 1,000 USD.

• Example: if the May VIX future is purchased at 25 and at maturity the VIX index is 26.2, the payoff is (26.2 - 25) x 1,000 USD = 1,200 USD.
• Obviously, loss equals to 1,200 USD for the futures seller

Question 7

What are volatility spread trading strategies?

Answer 7

• In volatility spread trading strategies, the trader takes a position on the differentioal (not the absolute level) of two different implied volatilites.
• Spread trading between underlying assets (e.g. stock indexes) or maturities
• The typical way to take a position is to combine:
• A long ATM straddle on one asset/maturity
• A short ATM straddle on the other asset/maturity