Volatility Change Before Expiration
Buy 1 OEX 600 Straddle at $17.10 Debit
(Buy 1 OEX 600 Call at $9.20)
(Buy 1 OEX 600 Put at $7.90)
Say OEX index fluctuated up and down around the level of 600, its level when the straddle was purchased, and 10 days after purchase (20 days before expiration) it was again at the level of 600. Time decay would have its natural, negative effect on the value of both options. But assume the investor initially bought the straddle motivated more by a predicted increase in option implied volatility than an expected change in the level of OEX, and that this prediction proved true.
The straddle was originally purchased at an implied volatility level of approximately 13%, but say the volatility level is now approximately 18%. What prices might the investor expect to see in the marketplace for both the long at-the-money call and put, given no change in interest rates or dividend yield of the underlying index?
OEX 600 call = $12.95 expected value
OEX 600 put = $11.70 expected value
OEX 600 straddle = $24.65 expected value
If the investor could sell the straddle at these expected values for both the call and put, the total received would be $24.65, or $2,465 total. The investor would make a profit:
$2,465 total sale price straddle
-$1,710 total straddle cost
The investor’s $775 profit after owning the OEX 600 straddle for 10 days, with the underlying index level unchanged, would come from the expected increase in option implied volatility. This $775 represents a return on the initial $1,710 investment of 44.2% over 10 days. If during this 10-day period the option implied volatility actually decreased, which was not expected by the investor, the straddle would most likely show a loss due to time decay with OEX unchanged at a level of 600.
If the level of OEX index had increased (or decreased) dramatically while owning the straddle, a profit might have been made from a concurrent increase in value of the call (or the put) instead, without an implied volatility increase.