Volatility trade design

Abstract

Despite the fact that they are heavily traded, discussed in every derivatives text, and necessary to aligning implied volatilities with volatility expectations, volatility trades such as straddles, strangles, and option/asset combinations have received scant attention in the finance research literature. Using a unique data set for the Eurodollar options market, the trading and structure of seven volatility trades-straddles, strangles, option/asset combinations, guts, butterflies, iron butterflies, and condors-are examined. We find that both traders' choices among the seven strategies and the designs they choose for the individual strategies indicate that volatility traders seek designs with (1) low deltas, (2) low transaction costs, and (3) high gammas and vegas. Among other things, these three presumed objectives explain why butterflies, guts, and condors are rarely traded; covered call and put writing is rare; and straddles are the most popular volatility trade. These objectives also explain the usual design of straddles, strangles, and asset/option combinations and the straddle-strangle choice. Our data also indicate that, in constructing their spreads, traders rely on Much of this research was completed while Ederington was Visiting Professor of Finance at the University of Otago and at Singapore Management University, whose support of this research is appreciated. We have benefited from the comments of an anonymous referee, Christine Brown, Timothy Crack, and participants in finance workshops at

Information content of options trading volume for future volatility: Evidence from the Taiwan options market

“…As suggested by Chaput and Ederington (2005), using the deltaneutral volatility trading strategy is more precise than using the Table 5 Volatility prediction by option volume of alternative combination trades. This table reports the estimation results of the prediction regression (Eq.…”

“…14 The straddle and strangle trades are commonly regarded as trades which are sensitive to volatility, 15 whilst the money and calendar spreads are less sensitive to volatility. As suggested by Chaput and Ederington (2005), the options/futures combination with a neutral delta is also a significant source of volatility trades; thus, we also identify this type of combination trade for the calculation of the volatility demand. 16 We calculate the volatility demand from these combination trades not only for the market aggregation, but also for the three main investor categories.…”

“…Referring to the Taiwan Futures Exchange (TAIFEX) reports, they also find that only market makers and foreign institutional investors earn money in the Taiwan option market. 7 As suggested by Chaput and Ederington (2005), a volatility trading strategy should have a low delta, a high gamma, a high vega, and low transaction costs. Chaput and Ederington (2003) show that the trading volume of combination trades, such as straddle and strangle trades are very sensitive to volatility changes.…”

“…7 We generate the trading volume of those strategies that are generally recognized as volatility trades, such as straddle and strangle, and also follow Chaput and Ederington (2005) to construct an additional volatilitysensitive trade, comprising of a combination of options and futures trades with an almost neutral delta and a non-zero gamma and vega. We also use trading volume for certain other popular combination trading strategies, including money spread and calendar spread, for the purpose of comparison.…”

Riding the swaption curve

“…6 In order to value the straddle we follow market practice and use the Black (1976) pricing model to convert quoted implied volatilities into straddle prices (Chaput and Ederington, 2005). To do so, consider a specific payer swaption giving the right to pay the fixed swap strike rate (F X ) and to receive the floating rate in a swap contract that will last n years (the tenor), starting in T years (the maturity), with m coupon payments per year and principal L. Let t i ¼ T þ i=2 be the times of each of the coupon payments.…”