Volatility Trade Design

Using data from the Eurodollar options on futures market, this paper examines six volatility trades: straddles, strangles, guts, butterflies, iron butterflies, and condors. We argue that straddles and strangles should have lower transaction costs than the other four strategies, and that (when constructed to be delta neutral) straddles, strangles, and guts should have higher vegas and gammas with a straddle's gamma and vega being the highest of the three. Consequently, we predict that in most situations volatility traders should prefer straddles and strangles to the other four strategies and that they should tend to favor straddles over strangles. Consistent with this we find that straddles account for 73.1% of all large volatility trades, strangles 20.8%, and butterflies 4.7% while the other three are rarely traded. In general we find that most straddles and strangles are designed so that their delta is low and their gamma and vega are high (in absolute terms) but that they are not always constructed so that delta is minimized and vega and gamma maximized. Specifically, we find that most straddle traders choose the closest-to-the-money strike and that most strangle strikes are centered around the underlying asset price. While delta is low and gamma and vega high at these strikes, they may not be the delta minimizing and gamma/vega maximizing strikes. On the other hand, we find that when futures are added to a straddle position it is almost always in the ratio that reduces the delta of the position to zero and that the volatility trader's choice of whether to use a straddle or strangle depends on which can be designed with the lower delta. There is little evidence that the shape of the smile impacts the strike price choices of straddle and strangle traders or that it impacts the straddle/strangle choice. We do find that the straddle/strangle choice depends on the time to expiration and whether the trader longs or shorts volatility.