Straddles: What's the Sweet Spot?
May 12, 2017
By: Sage Anderson
In the volatility trading space, the straddle has always been one of the bread and butter trades.
While traders rely heavily on metrics like Implied Volatility Rank (IVR) to evaluate whether volatility is cheap, fair, or expensive, the absolute value of a straddle also conveys important information to savvy traders.
Traders have a clear idea of how they win or lose when deploying a straddle trade. And straddles also help traders ascertain how risk is being priced in a particular symbol, or sector.
For example, if IVR is well above 50 in a particular name, a trader looking to sell premium may pull up the symbol and further consider the opportunity. At this point, the trader can look at the midpoint of the bid-ask spread on both the at-the-money call and put and calculate fair value for the straddle (in their preferred expiration month).
For example, if the call bid-ask in the front-month expiration is $1.40 at $1.60, and the put bid-ask is $1.60 at $1.80, than midmarket for this hypothetical straddle is $1.50 + $1.70 = $3.20.
Now imagine that the stock is trading for $40 and the prices evaluated above were for the front-month expiration month, with 20 days remaining until expiration. That would mean that if a trader bought the straddle, the stock would need to move more than 8% ($3.20/$40) prior to expiration to turn a profit on the position.
Next, the trader might check and see if earnings time falls in the front-month, or if any other catalysts that might affect the underlying stock price (aside from systemic market risk) are known to exist.
Going a step further, traders can also decide whether or not that they want to trade an at-the-money (ATM) straddle, or if they want to trade a straddle with a higher delta on one side versus the other.
A recent episode of Market Measures investigated this very question, and the results presented on the show are certainly of interest to anyone that routinely trades straddles.
In order to discover whether there’s been a historical “sweet spot” of call and put delta that has consistently outperformed over time, the Market Measures team ran a study dating back to 2005 on SPY straddles. The backtest looked specifically at selling each of the following straddles (put delta/call delta) over that window of time, and the relative performance of each:
20/80, 30/70, 40/60, 50/50, 60/40, 70/30, 80/20
Managed all trades at 25% of credit received
The results of this study are illustrated below, and show that the higher put delta straddles have tended to perform slightly better over time. However, one must also consider positive drift in the market (the slow grind higher), which could account for that slight outperformance:
Regarding the results from above, it’s important to keep in mind that the 50/50 (call delta/put delta) approach to trading falls in the “delta-neutral” category. Meaning that if a trader sells a 50 delta call and 50 delta put straddle, the trader would not have to theoretically trade the underlying stock against it as a hedge, because the position would be “flat” delta after deployment of the two option legs.
Whether you tend to trade delta-neutral or not, it’s important to be aware of the historical performance of the “lumpier” straddles in the event that conditions at some point warrant an adjusted approach. For this reason, we hope you’ll take the time to review the full episode of Market Measures focusing on the sweet spot for straddles when your schedule allows.
If you have any questions about these types of positions, we hope you’ll follow up at email@example.com, or leave a comment below.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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