Options straddles and breakevens

Level 2 - Intermediate Vol Trader

Most often we look at an asset class price, and its implied volatility and want to make sense of it. This article will exactly help with precisely that.

Here is the cheat code without going through Black-Scholes formulas, stochastic calculus mumbo-jumbo, partial differential equations, or finite differencing methods.

For an at-the-money straddle with N days until expiry, the amount of underlying asset movement for the position to break even is:

Price in % = 4.2*implied vol* sqrt(N)

You got it. It’s that simple.

Let’s take some examples.

If 1-day volatility is 12% (annualized), the option premium of at-the-money straddle = 4.2*12% = 0.5%

If 6-month vol is 4% (annualized), the option premium of at-the-money straddle = 4.2 * 4%* sqrt ( 180) = 2.25%

If 1-year volatility is 8% (annualized), the option premium of at-the-money straddle = 4.2 * 10% * sqrt ( 365) = 8%

Ok, you get the idea. We won’t delve into why the calculations for straddle premium are simplified in this post but we do love simplicity in estimates as they offer great insights into trade ideas. A lot of traders use volatility and ATR-based (Average True Range) stop losses and profit targets and a glance at the volatility curve (and basic high school math) can give them an approximate idea of straddle breakevens and premia.

There are 2 crucial caveats in this:

1. Firstly, interest rates have been ignored (set to zero) and so has the effect of forward carry.

2. Secondly, if the trader thinks that spot will move by more than the breakeven, it does not necessarily mean that the trader should purchase the option, perform delta hedging, and expect to monetize the position 100% of the time. When delta hedging is performed, there are more important considerations such as expected realized volatility which we can discuss in a later edition.
   
   Ok, let’s move on to another concept.

What is the probability that the option will move more than the breakeven price?