Trading option contracts allows you to not only place bets on the direction of the market, but also on the volatility of the market. For the option traders out there, this obviously goes without saying. The problem is that implementing the trades actually become more difficult when you think about potential outcomes and costs.
If you want the cleanest and simplest way to add volatility or vega exposure by using options, you would generally buy a straddle. A straddle will purchase the same amount of calls as puts with the same strike, time to maturity, and the same expiration. With this position, you basically want the market to move a lot in one direction. A pure long volatility strategy would delta hedge the straddle so that you can capture all large up and down moves in the market over the duration of the position (by scalping gamma).
Let us be simplistic in our thinking and only consider the vega of the position, or the change in the market value of the options due to a change in implied volatility. You see that the VIX is at fairly low levels and you want to make a bet that implied volatility is going to jump from 17% to 30% in the next three months. You think that this has to be a high probability trade so why not place the bet? You feel that it is hardly likely that implied volatility will fall below 12% and are willing to lose $250 on the trade. Therefore you want to be long a vega position of $50 per 1 vol point change in implied volatility.
You look at the 3 month options and you figure you can buy a put and a call on the SPY for about a 17% implied volatility. The issues that you will find are 1) your vega position declines as the straddle ages and 2) the vega profile is fairly peaked – meaning your vega position declines rapidly as the market moves away from the straddle strike:
Think about some market scenarios:
1) The market grinds upward away from your strike and your vega declines by 1/3 or more. Nothing happens for the next month, your option decays quickly with its fast theta and then the market drops quickly in the last month of trading.
2) The market fades slowly downward for 2 months as complacency sets in. Market drops quickly thereafter, but at that point your vega is small and the strikes (and what is left of the vega exposure hump) are much higher than the market’s current price.
So you go back to the drawing board and try to figure out how to get a smoother vega distribution with less time decay. Maybe adding to the maturity of the options will fix your problems:
Not really… A five year option has a great and flat vega profile, but you pay dearly for it. Instead of paying 17% as you did with the 3 month options, you are paying 24%. The one year is priced at 21% with a fairly flat vega exposure, but that only introduces one more issue…your options are not only ageing through their theta, but their market value is declining as it rolls down the term structure of implied volatility. The option that you bought for one year was priced using an implied volatility of 21%, but after 9 months it will be priced using an implied volatility of 17% (This is similar to why shorting VXX and going long VXZ usually works)
There are ways around these issues that will be explored later.