Volatility trade design

J. Scott Chaput and Louis H. Ederington

Journal of Futures Markets, 2005, vol. 25, issue 3, 243-279

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 heuristics that lead to relatively low deltas and high gammas and vegas, but not always the lowest delta and highest gamma/vega constructions implied by more sophisticated models. We find little evidence of trading based on the shape of the smile, that is, little evidence that trades are designed to long (short) strikes with low (high) implied volatilities. We find that some volatility trade structures—those that (1) receive considerable attention in finance textbooks, (2) have been posited by finance researchers, or (3) are recognized by the exchanges—are rarely employed by traders, whereas others are quite common. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:243–279, 2005

Date: 2005
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