The life of a straddle buyer could properly be characterized as perpetual disappointment punctuated by the occasional flash of brilliance. Over time, the long straddle produces many losers and few winners. Chalk this up to the so-called volatility risk premium that exists when the implied volatility built into an option’s price is higher than the subsequent volatility realized by the underlying asset throughout the life of the option.
In simple terms, options are persistently overpriced. And since the long straddle involves purchasing both a call and a put option, it’s a tough trade to consistently make money with.
While many tout the long straddle as a bi-directional trade, let’s not forget it’s also at its heart a long volatility play. To say the purchase of a straddle is a bet that a stock will move up or down is a bit misleading. Consider the long straddle as the expression of your opinion that the stock will move up or down MORE than the market expects. You’re effectively betting the option market has it wrong — that it is underpricing the volatility soon to be realized by the underlying asset.
The successful implementation of long straddles then is a by-product of impeccable timing. It requires identifying environments of opportunity where a volatility explosion is imminent and option premiums are on the cheap.
Such a setup is often revealed through the compression in Bollinger bands, the formation of a symmetrical triangle, or other such signals of a coming volatility surge.
Yet, the identification of such a setup is merely half the battle. One must also assess a volatility chart to ascertain the relative cheapness of option prices. In the event implied volatility is low enough, long straddles may indeed prove fruitful.
Technology rock star Apple (NASDAQ:AAPL) currently provides a compelling case study for the long straddle. From a chart perspective, it has been basing for over a month in the $570-$580 area. In volatility terms, we’d say the stock is coiling, or experiencing a compression in volatility as reflected in the Bollinger Bands, which have narrowed in recent days to their tightest levels in over six months.
If you subscribe to the notion that volatility regimes alternate between periods of expansion and compression, then you’re likely in the camp that contends a volatility expansion is looming.
At the same time, implied volatility (VXAPL) is approaching the lower level of its multiyear range, making options appear somewhat cheap relative to where they usually trade.
Bottom line: Long straddles appear more compelling on AAPL than they have in a while. If you’re not a fan of straddles, then buying volatility in some other fashion works as well. If you’re bullish on AAPL, long calls aren’t a bad way to go, if bearish try long puts.
At the time of this writing Tyler Craig had no positions in AAPL.