Volatility Spreads Flashcards
1
Q
Straddle
A
- Call and a put where both have the same exercise price and expiration date
- Both are either purchased (long straddle) or sold (short straddle)
- Long straddle is more valuable as the underlying market moves away from the exercise price
-long straddle is less valuable as time passes and no movement occurs
-Long straddle: Increase in vol will increase value and vice versa
-Long straddle Greek considerations:+ Gamma (desire for movement in the underlying contract) -Theta (the value of the position declines as time passes)
+Vega (the value of the position increases as implied vol rises)
-Straddles are most often executed 1 to 1 using ATM options
When this is done, the spread will be approximately delta neutral because the delta values of the call and put will be close to 50 and -50
Can still do straddles not ATM and just adjust them for the delta, making them ratio straddles
unlimited potential upside and the risk is only the premium outlay
2
Q
Strangle
A
- Consists of long call and long put or short call or short put where both options expire at the same time, the difference being that the options have different exercise prices
- Most often done 1 to 1 and exercise prices are generally chosen to ensure delta neutrality given the call and put
- To avoid confusion on the quoting convention, a strangle is assumed to consist of out of the money options
- Ex) if the underlying market is 100 and the trader wants to buy a march 90/110 strangle, the assumption is that he wants a 90 put and 110 call
- If a strangle consists of out of the money options it is sometimes referred to as a guts
- Greek considerations of long strangle
+ gamma
-theta
+vega
Inverse holds for short strangle
Unlimited potential upside and the risk is only the premium outlay
3
Q
Butterfly
A
- Three sided spread consisting of options with equally spaces exercise prices where all options are of the same type (either calls or puts) and expire at the same time
- Long butterfly: Outside exercise prices are purchased and inside is sold
- Short butterfly: Outside exercise prices are sold and inside is purchased
- It is always “1 x 2 x 1”
- at expiration, a butterfly is worthless if the underlying contract is above or below the outside exercise prices
- Sometimes called the wings of the butterfly
- Maximum value if the underlying contract is right at the inside exercise price
- Called the body of butterfly
- Butterfly is delta neutral when the inside exercise prices are at the money
- Under delta neutral conditions, one can think of a long butterfly like a short straddle and a short butterfly acts like a long straddle
- Long butterfly greeks
-gamma
+theta
-vega - Inverse holds for short butterfly
- While straddle is open ended in terms of profit potential, butterfly is limited
For this reason butterfly’s tend to be done in higher notional amounts to capture greater profits
4
Q
Condor
A
- Consists of four options, two at the inside price (the body) and two at the outside exercise price (the wings)
○ The ratio is always 1 x 1 x 1 x 1
○ Must be an equal amount btw the two lowest exercise prices and the two highest exercise prices
○ All options must expire at the same time and be of the same type (all calls or puts)
○ Long condor = buy the two outside legs and sell the inside
Short condor = opposite
-The value at expiry can never be less than 0 or more than the difference between the two higher or two lower exercise prices - Condor is delta neutral when the underlying contract is midway between the two inside exercise prices
○ Straddles, strangles, butterfly’s and condors have no preference to the direction of the underlying when performed delta neutral
○ Long condor = +gamma, -theta, +vega
Short is the opposite
5
Q
Ratio Spread
A
- A trader who believes the movement in one direction is more likely than a move in the other can use ratio spreads
- Buying and selling an unequal number of options where all the options are of the same type and expire at the same time
- As with other volatility positions, the spread is typically initiated delta neutral
- Ratio spread is where more options are purchased also called a backspread sometimes
○ +gamma, -theta, +vega - Ratio spreads are often used to limit risk in one direction
- Ratio spread where more options are sold is called front spread
6
Q
Christmas Tree
A
- Designed to mimic strangles but with limited risk and reward
- Also called ladders
- Involves buying a call at a lower exercise price and selling one call each at two higher exercise prices
- All options must be the same type and expire at the same time with exercise prices usually chosen so that the entire package is delta neutral
- Ratio spreads and Christmas trees have nonsymmetrical P&L graphs, their vol characteristics tend to mimic straddles and strangles
- A spread in which more options are purchased than sold will prefer movements in the underlying
○+gamma -theta, +vega
Vice versa is also true
7
Q
Calendar spreads
A
- Also time spreads or horizontal spreads
- Consists of option positions that expire in different months
- Most common type consists of opposing positions in two options of the same type (either both calls or puts) where both options have the same exercise price
○ When LT options are bought and ST options sold, trader is long the calendar spread (and vice versa) - Value of spread depends not only on the movement in the underlying but also on the markets forward expectation of implied vol movements
○ Because of this, calendar spreads have important distinction than all those discussed above, summarized w the following 2 points:
1. Calendar spread will increase in value if time passes w no movement in the underlying contract
2. A calendar spread will increase in value if implied vol rises and decline in value if implied vol falls - Important consideration is that as time to expiry grows shorter, the theta of an ATM option increases.
-A ST ATM option decays more quickly than a LT ATM option - Volatility: as it raises or lowers, both options rise or fall in value, but the LT option does so more quickly
○ A change in vol will have a greater effect on a LT option than the equiv ST option
○ LT options have > vega than ST options
○ This difference in sensitivity to a change in vol causes the calendar spread to widen if we increase vol and narrow if we reduce vol - Trader who is long a calendar spread wants the market to remain unchanged but the expectation of vol to spike
○ This can happen around earnings or anticipated news events - Long calendar greeks are different than everything discussed above due to this stipulation re vol
○ -gamma, +vega
Short calendar = +gamma -vega - Assumptions can differ for the above in different markets like commods where S&D factors can cause the underlying to move in different directions
- Bc of this it is common for a futures market trader to ofset a calendar spread w an opposing position in the futures market
Ex) if a trader buys the march/june cal spread, he can offset the position by purchasing march futures and selling june futures
8
Q
Time Butterfly
A
- Options w the same exercise price but three different expiration dates
- All must be the same type, w approx the same amount of time between expiries
Buying or selling the LT option and taking the opposite position in the ST option - If all options remain ATM as time passes the value w increase
- Long the butterfly is buying the LT and selling ST
○ Long TB - the value will collapse as the underlying contract moves away from the exercise price, so the spread has negative gamma
○ Has positive theta
Value of spread declines as vol decline, so positive vega
