Definition Rules for Buy/Sell Directions in Option Combinations
Definition Rules for Buy/Sell Directions in Option Combinations
Visit the Mathema Option Pricing System for pricing and valuation of FX combination options and client combination option products!
The market has a set of common conventions for defining the buy/sell directions of combination options such as Strangle, Straddle, Butterfly, and Risk Reversal. These conventions aim to ensure that both parties in a trade have a clear and consistent understanding of the combination's buy/sell direction. This is particularly important in the interbank market, where unified definitions help reduce misunderstandings and improve operational efficiency.
Below are the market rules for defining buy/sell directions of these combination options, along with detailed explanations:
1. Market Rules for Defining Buy/Sell Directions of Combination Options
1.1 Buy the Combination
- Buying the combination refers to the direction of net long positions in the combination option.
- If the total net cost of the combination is positive (paying a premium), it is defined as buying the combination.
1.2 Sell the Combination
- Selling the combination refers to the direction of net short positions in the combination option.
- If the total net cost of the combination is negative (receiving a premium), it is defined as selling the combination.
1.3 Default Directions for Call and Put
- For any combination, buying a Call or Put is considered buying volatility (positive Vega).
- Selling a Call or Put is considered selling volatility (negative Vega).
1.4 Core Principle of Combination Direction
- Buying the combination: Typically implies increased sensitivity to the underlying asset's price volatility (increasing volatility or trend risk).
- Selling the combination: Typically implies reduced sensitivity to the underlying asset's price volatility (decreasing volatility or trend risk).
2. Buy/Sell Directions for Various Combination Options
Below is a detailed explanation of how the buy/sell directions are defined for Strangle, Straddle, Butterfly, and Risk Reversal:
2.1 Straddle
Definition:
- A Straddle involves buying or selling a Call and a Put with the same strike price.
- The two legs have symmetric Delta (Call has positive Delta, Put has negative Delta).
Buy Straddle:
- Simultaneously buy an ATM Call and an ATM Put.
- Expresses an expectation of increased market volatility (positive Vega strategy).
- Total cost is positive (paying a premium).
Sell Straddle:
- Simultaneously sell an ATM Call and an ATM Put.
- Expresses an expectation of decreased market volatility (negative Vega strategy).
- Total cost is negative (receiving a premium).
Market Convention:
- Buy Straddle = Pay premium, buy volatility.
- Sell Straddle = Receive premium, sell volatility.
2.2 Strangle
Definition:
- A Strangle involves buying or selling an OTM Call and an OTM Put with different strike prices.
- The two legs typically have symmetric Delta, e.g., +25 Delta Call and -25 Delta Put.
Buy Strangle:
- Simultaneously buy an OTM Call and an OTM Put.
- Expresses an expectation of significant price movement in the underlying asset (positive Vega strategy).
- Total cost is positive (paying a premium).
Sell Strangle:
- Simultaneously sell an OTM Call and an OTM Put.
- Expresses an expectation of low price volatility in the underlying asset (negative Vega strategy).
- Total cost is negative (receiving a premium).
Market Convention:
- Buy Strangle = Pay premium, buy volatility.
- Sell Strangle = Receive premium, sell volatility.
2.3 Butterfly
Definition:
- A Butterfly involves buying and selling options at three strike prices:
- Buy 1 lower strike option (Call or Put).
- Sell 2 middle strike options (Call or Put).
- Buy 1 higher strike option (Call or Put).
- The three strike prices are typically symmetrically distributed: , with .
Buy Butterfly:
- Expresses an expectation that the underlying asset price will remain near the middle strike price.
- Total cost is positive (paying a premium).
- Buy Butterfly = Buy the wings (lower and higher strikes) and sell the body (middle strike).
Sell Butterfly:
- Expresses an expectation of significant price movement in the underlying asset.
- Total cost is negative (receiving a premium).
- Sell Butterfly = Sell the wings and buy the body.
Market Convention:
- Buy Butterfly = Pay premium, buy limited volatility.
- Sell Butterfly = Receive premium, sell limited volatility.
2.4 Risk Reversal
Definition:
- A Risk Reversal involves buying an OTM Call and selling an OTM Put (or vice versa).
- The two legs typically have symmetric Delta, e.g., +25 Delta and -25 Delta.
Buy Risk Reversal:
- Buy an OTM Call and sell an OTM Put.
- Expresses a bullish view on the underlying asset price and a demand for positive skew in volatility.
- Total cost may be positive or negative, depending on the implied volatility difference between the two legs.
Sell Risk Reversal:
- Sell an OTM Call and buy an OTM Put.
- Expresses a bearish view on the underlying asset price and a demand for negative skew in volatility.
- Total cost may be positive or negative, depending on the implied volatility difference between the two legs.
Market Convention:
- Buy Risk Reversal = Bullish directional view, buy positive skew.
- Sell Risk Reversal = Bearish directional view, buy negative skew.
3. Summary: Market Definitions for Buy/Sell Directions of Combination Options
| Combination | Buy the Combination | Sell the Combination |
|---|---|---|
| Straddle | Buy ATM Call + Buy ATM Put (neutral direction, buy volatility) | Sell ATM Call + Sell ATM Put (neutral direction, sell volatility) |
| Strangle | Buy OTM Call + Buy OTM Put (neutral direction, buy volatility) | Sell OTM Call + Sell OTM Put (neutral direction, sell volatility) |
| Butterfly | Buy wings (lower and higher strikes) + Sell body (middle strike) | Sell wings + Buy body (neutral direction, limited volatility) |
| Risk Reversal | Buy OTM Call + Sell OTM Put (bullish direction, buy positive skew) | Sell OTM Call + Buy OTM Put (bearish direction, buy negative skew) |
4. Practical Considerations
Ensure Symmetric Delta for Legs:
In the interbank market, the buy/sell direction of combination options is typically based on symmetric Delta legs (e.g., +25 Delta and -25 Delta). If the Delta is asymmetric, it must be explicitly stated.Confirm Direction Based on Cost:
A total positive cost (paying a premium) usually defines buying the combination, while a total negative cost (receiving a premium) usually defines selling the combination.Confirm Call/Put Directionality:
Buying a Call or Put = Buying volatility. Selling a Call or Put = Selling volatility.
By adhering to these market conventions, trading parties can avoid misunderstandings caused by inconsistent definitions of combination directions, ensuring smooth transactions.