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Creating The Bottom - Part 2 of 2
Last week, we left off with an indication that straddles have some risks with which the trader must contend. Chief among them: implied volatility. In fact, if you can manage the effects of implied volatility in a straddle, you're doing pretty well.
The rule of thumb regarding implied volatility and options is pretty straight-forward. When prices are falling or uncertainty about some upcoming event is running high, implied volatility will tend to increase. That inflates the value of options. Under the reverse circumstances, implied volatility tends to be falling and therefore deflating the value of options.
Let's consider a straddle that is entered when the underlying is descending. While the straddle may be completely neutral concerning the direction of the underlying stock, it is not neutral with regard to implied volatility. Thus, it will not behave as one might expect in that it will not profit equally regardless of which way the stock goes. If the underlying keeps falling, the straddle should benefit from rising implied volatility, which will enhance the directional profits. If the underlying rises, the straddle may be hurt by declining implied volatility, which would offset the directional benefits. In other words, the straddle that appears totally neutral to up or down stock movement is, in fact, inherently biased toward the downside.
What, then, is the hedge for the straddle's exposure to implied volatility?
The underlying stock is the hedge. Recall that last week we spoke of a "biased" straddle. We bias it by adding shares of long stock. What we are effectively doing is counteracting the implied volatility bias inherent in the position. If the underlying falls, the straddle would be expected (but not guaranteed) to increase in value because of the beneficial implied volatility effect. In this case, the extra long shares we have would be designed to offset some or all of the expected implied volatility benefit, essentially filtering it out so that the profits come mostly from movement in the underlying.
If the underlying rises, the extra long shares add profits that are being lost due to decreasing implied volatility. This, again, filters out the implied volatility impact and leaves us, ideally, with mostly directional exposure.
In biasing our straddle with shares of the underlying, we are attempting to mitigate the inherent bias associated with implied volatility. As such, our biased straddle is more truly neutral.
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Creating The Bottom - Part 2 of 2 
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