From the Archives: The Straddle -- Key to Understanding the Listed Options Market

On Wednesdays, we re-publish columns written by the inventor of Implied Risk, Jim Yates. Today's article in From the Archives was originally published on April 25, 1988.

Prior to the creation of the listed option market in 1973, most writers sold straddles. A straddle consists of a put and a call on the same stock with the same expiration and exercise price. The number of option writers was small, as was the entire options business. Straddle writers were the financiers of the business. They invested their capital in low-risk positions, usually municipal bonds, and agreed to buy or sell a stock at a price for the put and call premium.

When the listed options market began, straddle writing was not possible in the same way it had been in the old market. The new market was calls only. It was possible to establish a ratio-write position by buying 100 shares of stock and selling two at-the-money calls. This position was the equivalent of a straddle but because it required that the old underlying capital be invested in the stock, most of the old writers were not very interested. In addition, the new market offered much lower premiums, which suggested lower returns. This, among other reasons, led the old pros of the business to conclude that the new market had little chance of success.

The most important development leading to the establishment of the new market was the Black-Scholes option pricing model. The model determined the value of an option by calculating the premium needed to exactly neutralize a stock position and return the risk-free rate. Initially the market was calls only, but by 1980 calls and puts were traded on all stocks. With both puts and calls trading, it was now possible to establish straddles in the listed options market.

A straddle is an example of neutral risk position. The new model determined the fair value of such a position, which meant its goal was to determine the value for the position that would not yield an advantage to the writer or buyer. Naturally, writers who were accustomed to high returns for risking their capital were not happy. The most important factor in the model was the volatility assumption. If the volatility assumed was too high, the premium value would be excessive and writers would earn an excess return. If the assumption was too low, the buyers benefited. As the market grew over the past 15 years, the ability of the market to adjust to changes has steadily improved.

Straddle writing in the listed option market has had its good years and its bad years. The late 70's were good years. 1980 was a bad year, as have been the past two years. One factor that has led to big troubles for writers has been the ability to leverage positions. Under current margin requirements, it is possible to leverage straddle writing on individual stocks by a factor of 5 to 1. In the index options market, this number, until recently, was 20 to 1. The result was that the negative periods which appear as relatively small moves were in fact huge if the position was fully leveraged.

The strategy has performed as designed. The beta factor for a T-bill straddle portfolio should be close to zero if it is in fact a neutral strategy. The numbers for both the last five years and since the start of listed options trading confirm this assumption. As the market has grown, the profitability of the strategy has declined. This leads us to conclude that the option market is becoming better at its job of handicapping the market; in other words, it is becoming increasingly efficient.

While an efficient listed option market is bad news for those seeking a free lunch from option writing, it may be good news for those looking to the option market for information. An efficient market means that the market has good handle on expected volatility. That means that the implied volatility that can be determined from prices in the option market are becoming more accurate. It has often been noted that "if you can't beat 'em, join 'em." Since it is hard to beat such an efficient market, it may be a good time to observe the market and study its tendencies.

A straddle is essentially an expression of the price distribution expectations for the underlying stock or index. A straddle with a large premium value indicates a stock with a wide price-band expectation. The volatility assumption may allow us to determine exactly how much the price of a stock may deviate from its longer trend under normal conditions. That concept is the basis for the data in our reports. The Option Phase Chart was initially tested by determining the equivalent market position of a continuously managed straddle portfolio. The scale of scale of the Option Phase Chart comes from the expected range of observations for the account. It is expected that the account will vary from a maximum equivalent long position of 50% to a maximum short position of 50%. Most of our observations should be in the +/- 20% area.