Monday, November 17, 2008

Effects of Volatility on the Performance of Options and Straddles. Can Declining Volatility Still Produce Profits?

While straddles and strangles have been stellar performers in recent months, questions arise as to the performance when volatility decreases. In the last few months volatility has increased significantly, and this causes options premiums to increase. Therefore, part of the gain of buying straddles is due to the rise in VIX. The question is then, can an investor still make a profit when volatility declines?

The table below shows some values for a period of time, from October 28 to November 4, when the VIX dropped from 76 to 44. During this time IWM went up from $45 to to $55. The tables shows the return of three call options, 40, 45, 50, and 55.

And this is the corresponding table for the puts during the same period:

The average increase in call premiums was 343.2%, while the average decrease in put premiums was -86.4%.

Based on this small sample, straddles also work fine in an up market. Any return over 100% would be guaranteed to return a profit, even if the puts dropped to $0.

Chart for VIX, IWM, and Call 40 and Call 45:

(Please click on image to enlarge)

Chart for VIX, IWM, and Call 50 and Call 55:

(Please click on image to enlarge)

Now for comparison purposes, we look at the period immediately after, November 4 to November 14, when the VIX rose from 44.5 to 70 (+57.3%). During this period, IWM dropped from $55 to $43.50 (-20.9%). The table below shows the performance of the corresponding puts.

And again, the performance of the calls during the same period:

The average increase in put premiums was 570.1%, while the calls dropped -85%.

The figures below show the charts for the puts during the rising volatility period:

(Please click on images to enlarge)


We looked at two similar length periods, the first one when the VIX dropped 42.1%, and the second one when the VIX rose 52%. Clearly the performance is better in periods of rising volatility (in our case, approximately 66% better). However, in either case the straddles were profitable, as shown by the tables below.

Straddles and Strangles:

The call 60 was added to the above in order to have a a similar strangle in both periods.

  • During decreasing VIX the straddle returned +40%, while the $5 strangle (off by $5 from the current price) returned +80%.
  • During rising VIX the straddle returned +121%, while the $5 strangle returned +722%.

Stumble Upon Toolbar


chlo888 said...

Hi Shocked Investor...
Thanks for posting all the great info. I do straddles on the e mini futures options. I sell the puts and calls of the same strike price. If one side of the trade starts to move out of the premium range, I hedge with the futures. This method worked like a charm until the large swings we started having in Sept and even then I just broke even since I hedged the downside with the futures.

My question with your IWM straddles is do you make money on most all of your trades when you do a straddle on the IWM? You have posted the trades that have been profitable but I was wondering if you left the unprofitable trades out? Also, it appears from your post that the best time to initiate a straddle is at a market top since the higher VIX reading (that will ensue after a decline from a top) works to the advantage of the investor and of course the decline will result in the puts' gain being larger than the call.

Am I correct in that assumption?



The Shocked Investor said...

Hi Glenn,

Thank you for your comment. Last options month all straddle I positions were profitable with the exception of one of them (the day before expiration). As noted in the latest posts, this month volatility has not been as high, but the straddles in general are still profitable. The point is that there is always an exit point for any straddle bought, be it 5%, or 10%, or 25%, to whatever the desired profit/exit is. The current VIX study shows that positions were profitable even in rising markets, but yes, you are correct, profits are larger if you buy at market tops, when volatility will be rising. Volatility is a bit of a misnomer, as it rises when the market drops. It is more of a measure of bearishness. I did not leave out any losing position from the report at all (they may still exist), however, this month I did not look at every single position, as was done last month, where a straddle was bought every time IWM crosses an integer $ value.

As for your strategy, if you are selling both calls and puts of the same strike and these are for the current month, then you are basically taking the opposite approach. I believe this strategy will work under two conditions: in times of low volatility and for short term straddles.

In times of low volatility, the profitable straddles are the ones bought 6 month out, the opposite as it is now. I am not sure how you are hedging with futures, so I cannot comment.

In general it is always better to write options as most expire worthless. Selling options however, cannot be done by small investors or in registered accounts (in Canada), so buying options (like straddles) is a good way to benefit in these times of high volatility. it works... until it doesn't

Please note that options are always dangerous and I am not a financial adviser.

Financial TV

// adding Google analytics