A manager projects a significant unexpected increase in currency volatility and is highly confident in his volatility opinion. Which of the option trade would be the best to select? Straddle or strangle?
Straddles have higher payoffs; strangles are cheaper.
Which do you think is better?
Indifference?
If you have high confidence, do u want to go cheap and get low payout or go big and hit a homerun?
too much of confidence might lead to an overconfidence bias, no ?
From % return perspective - strangle
Straddle provides better returns than Strangle on high volatility.
Not necessary true. If you trade options ever, things become a lot more clear then reading from a book.
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If you buy DITM options, you likely will have less percentage return and but odds of getting a return are high.
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If you buy ATM options, your odds of return are less but you have a higher payout (straddle)
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If you buy OTM options, your odds of return get much worse, but your payout potential is much higher. Sometimes 100-1000% in days (strangle)
People buy otm options all the time because they’re aiming for home runs. Most the time, the otm options expire worthless. The strangle easily has 100-300% returns if the stock moves heavily, especially after earnings call. The Straddle like an atm option is expensive and returns will be adjusted accordingly.
LOL. I believe that is called Hindsignt bias.
E(High volatility) -> V-shape payoff chart - Go straddle
E(Low-volatility)-> A-shape payoff - go Strangle.
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A-shape is short straddle.
Right, but it’s not necessarily true that Strangle provides better returns either. The key is entry price, which depends on volatility and the skew. Since original question is missing these information, we can assume uniform volatility across strikes. In such as case, Straddle provides higher return than Strangle in high volatility environment (i.e. volatility is going to spike after our purchase).