With the implied volatility of the S&P 500 Index (as represented by the VIX) touching 18 and the 20 day Realized Volatility down at around 8%, I’ve been hearing quite a bit from students and colleagues about long gamma positions – straddles in particular.  The idea is that volatility is so low that options are under-priced and should be purchased in bulk to profit from the impending price explosion. Without necessarily arguing for or against that position, what follows are some thoughts on what I believe to be very basic options strategy. The purpose of the straddle is to profit from either a gain in Implied Volatility or Realized Volatility (ie:  a sudden change price movement).  Since most beginning traders buy straddles in the hope of cashing in on an unforeseen breakout, it makes sense to begin with a quick discussion on realized (historical) volatility.

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A Backspread for High and Low Volatility Environments

The Ratio Backspread is a hell of a trade.  When positioned at different points along the option chain, the same trade can have completely opposite price and volatility outlooks.  As an introduction to the spread, I’d like to illustrate two of the Backspread’s most widespread applications.

The Common Backspread

The most popular way to create this position is with the purchase of two at-the-money (ATM) options and the sale of the sale of one in-the-money (ITM) option.  The trade is most often established for a credit by selling an ITM strike that has a premium of at least twice the cost of the ATM strike.  

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The Earnings Ratio Condor

Just as it is common for at-the-money implied volatility to rise leading up into an earnings announcement (as discussed in The Earnings Straddle in Different Flavors), it is also common for the curvature of the volatility skew to become more pronounced.  This latter phenomenon is perhaps less common than the former and is certainly more difficult to identify (and to trade, for that matter), but that is not to say that it doesn’t exist and can't be exploited.

Allow to me to explain with an illustration.  Below is a mockup of the vertical skew of a typical big name stock going into earnings.

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The Earnings Straddle in Different Flavors

A common phenomenon during earnings season is for implied volatility (IV) to rise in anticipation of the event.  The most common strategy to capitalize on this is the purchase of an ATM call and put: the long Straddle.  The Earnings Straddle however, comes in different flavors—some with more bite than others.

The Vanilla Earnings Straddle

The inexperienced trader will purchase the straddle the day prior to an earnings announcement with the intent of profiting from an explosive move in the underlying.  While these moves often do indeed occur, they are rarely reciprocated with an appreciation of the straddle.

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