High volatility when expecting breakout

hi Wayne(and all option gurus out there)

in theory you would buy when volatility is low and sell when it's high. when u expect a breakout but not sure which way a long straddle comes into your mind. but what if at that particular time IV is very high? how would u deal with a dillemma like this?

any help appreciated
hissho

hissho,

I reckon its a great question - I'm new to options and the same question came to mind this week. My take on it at the moment after thinking it through is this:

Firstly my thinking went like this:

* If IV is high then we should theoretically be writing rather than buying options so we capitalise on the high IV.
* Which means a long straddle doesn't seem like it makes sense if IV's are high because we're paying for the high IV.

However a point that Wayne made in another thread comes to mind - which is IV is relative - a low IV stock still has high and low cycles and the same applies to a high IV stock.

So if you are expecting a breakout - that to me implies you are expecting true volatility to rise - i.e. even though IV's might already be high you are actually expecting them to rise because you're expecting the stock to break out significantly from its current range.

So I think that in that situation the long straddle still makes sense. I also think that the fact that IV's are high implies that other traders also think that a breakout is likely - so you are betting with the crowd.

An alternative is to bet that no breakout will occur, against the crowd, by shorting some options near the money on both sides (with spreads to protect the downside risk) but of this of course is going directly against your expectation (however statistically it might be the safest thing to do!).

I guess the other question is - what will happen to IV after a breakout - will it collapse (e.g. if its a capitulation breakdown then IV's might collapse after the actual breakdown, but if its the start of a new rally IV's could stay high). And if you have a viewpoint on that how does that affect the strategy.

Some more thoughts - maybe a long strategy but closer to the money (strangle?) might be appropriate as well - ATM options have higher IV but the IV is more stable from my understanding -i.e. it won't collapse as quickly as the IV in OTM's - so if the expected breakout doesn't ensue you can still recover IV on the ATM's on sale while with the OTM options the IV will collapse more quickly if the stock trades in a stable range.

As you can see my thoughts are all over the place on it ...

So good question - it gets to the heart of options strategy and the complexities therein - bring on the experts!

hissho said:

hi Wayne(and all option gurus out there)

in theory you would buy when volatility is low and sell when it's high. when u expect a breakout but not sure which way a long straddle comes into your mind. but what if at that particular time IV is very high? how would u deal with a dillemma like this?

any help appreciated
hissho

Click to expand...

This is a dilema. The side effect of hi IV in a straddle, is higher vega and theta. This of course is in double quantity...and there is a very real risk of the dreaded volatilty sag (vega risk)

To compound that, gamma is reduced also. So to put this strategy on under the circumstances requires a BIG move. IV won't necessarily increase with a big move either, particularly if the move is news based and can actually decrease.

So what to do?

Well you can just stand aside until risk reward improves

The can try and anticipate a direction and put on a directional strategy (or wait till a directional signal appears)

You could go for a written strategy, but this would require a thorough analysis of where any black swans may reside. It would probably be irresponsible of me to discuss these without knowing peoples risk profiles etc.

Cheers