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Why You Can Win on Volatility But Lose on a Trade


In this example, a straddle buy could lose $0.23 per contract even though the volatility bet was right.

Okay, the point that you could win on volatility but still lose on a trade that involves actual options is a tricky one. So let's look at an actual example:

Suppose SPDR S&P (SPY) closes at 117 on Thursday, ahead of the three-day holiday weekend. Using a 15 volatility, the April 117 straddle will have a value of $2.83. How about we buy that straddle, or in other words, buy 15 volatility.

Now we return to the turrets on Monday, and SPY still trades 117. But volatility has soared all the way to 16. So you won, right? I mean you went long volatility and it lifted a point.

Well, guess again. With SPY 117 next Monday, the straddle you bought for $2.83 now has a value of $2.60. In actual dollars, you lost $0.23 per contract, even though you made the correct volatility bet in volatility terms.

Again, volatility moves like these over a weekend or holiday are predictable. You buy and sell actual options in actual dollars though. The bet you make on Thursday is not a bet on what a volatility statistic will spit out. Rather it's a bet on the value of the straddle going forward. And that bet has both a volatility and time component.

There's also a reverse example of this. Suppose SPY gaps up to 120 and volatility opens down at 14? The intrinsic value alone of the straddle is worth $3, you clearly win.

Now I know, I know, forget about actual options, how about buying April VIX futures? Well, the move in volatility in this example from 15 to 16 would likely not budge the future one iota. They may even drop.


Because the April VIX future is not spot VIX. It snapshots VIX on April expiration day (April 21). A little weakness ahead of a holiday and an illusion of a rebound after the holiday have literally zero impact. If anything, the overnight unchanged would likely cause April VIX to sell off, that part is real.

Click Here to Read Adam Warner's "Trading Option Backspreads"
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