"Options traders can use a neutral position delta strategy to make money when implied volatility declines." (http://www.investopedia.com/terms/d/deltaneutral.asp) Isn't that statement wrong? Because if IV declines then usually the option value declines as well.
I. A delta neutral position will stay delta neutral, for the most part, if the underlying stays the same. II. A delta neutral position, which is also short volatility will make money when implied volatility declines. III. A delta neutral position which is long volatility will loose money when implied vol increases. Additionally, the short straddle graph will shift upward and downward along the Y axis of the PnL graph with changes in implied volatility. a) an up move in IV makes the straddle more expensive, resulting loss to the short seller. b) a down move in IV makes the straddle cheaper, resulting in a gain for the short seller
Will it not continue staying delta neutral if the underlying is moving? (as opposed to "stay the same"?) How is this supposed to work in practice? I mean "how to short volatility" in practice? Using which instruments? So, then the opposite should be this, right?: "A delta neutral position which is long volatility will make money when implied vol declines." But isn't that contradicting your 2nd statement?
QUOTE="mutluit, post: 4143406, member: 267934"]Will it not continue staying delta neutral if the underlying is moving? (as opposed to "stay the same"?) No. A move in the underlying will change the level of options spreads' delta (neutrality). How is this supposed to work in practice? I mean "how to short volatility" in practice? Using which instruments? Short Straddle is the most efficient example of being short volatility. To maintain delta neutrality, you will have to apply hedging as the underlying moves. A lot of discussions assume continuous hedging, but in practice you will have to apply discrete hedges based on parameters of your choosing or risk tolerance. ie Maximum delta (un-neutrality) tolerance, Maximum gamma risk, maximum vega risk ...etc etc. So, then the opposite should be this, right?: "A delta neutral position which is long volatility will make money when implied vol decreases." But isn't that contradicting your 2nd statement?[ QUOTE] No, it does not. It is a description of a long straddle position which is also delta neutral. Read your original statement that started the thread. And, ask yourself if investopedia is mistaken.
Oops. I caught my typo regarding a long vol position loosing money: should be " when implied vol decreases". So with that correction, I still say that investopedia is correct.
There are any number of ways to construct a position which profits when volatility drops. Consider calls and puts: their value rises in a rising volatility environment, all other things being equal. They have positive "vega". So if you're long a call or put, your position gains value as volatility rises. (We are ignoring delta effects in this discussion.) How would we reverse that, so your position gains value when volatility drops? We short the calls or puts. In the same way, more complex positions -- spreads, etc. -- have net vega. If net vega is positive, you want volatility to climb. If net vega is negative, you want volatility to drop.
Just remember that it was a short straddle position initiated by rogue trader Nick Leeson that brought down Barings Bank. Like an unhedged short call position, short straddles have theoretically unlimited risk.