This is an advanced topic in Option Theory. Please refer to this Options Glossary if you do not understand any of the terms.
The straddle approximation formula gives a pretty accurate estimate for the price of an ATM straddle, given the current stock price, implied volatility, and the time to expiration.
Even though it is only an approximation, it is accurate enough that we can derive other results from it.
An approximation of the ATM options is given by
This can be derived from the Black Scholes formula (see below).
The straddle approximation formula is
Note that the time scale of the time to expiry and volatility has to be the same. As such, different places may quote you a different formula, depending on whether they are using "trading-day volatility" or "calander-day volatility." For simplicity, I will use "trading-day volatility," where a 16% volatility implies a daily variance of 1%. In this case, we have the approximation
where the time is measured in terms of the number of trading days to expiry, and is volatility measured in %.
Note: I choose to use the number of trading days, as it is easier to say "30 trading days to expiration," compared to "0.118 trading years to expiration." Similarly, because volatility is often recorded as a percentage, it is easier to use that number directly. This explains why my constant is so small, compared to the oft-quoted 0.8.
What is the ATM straddle price for a stock that is trading at 30, with a trading day volatility of 16% and 9 days to expiry?
Differentiating with respect to volatility, we see that
In particular, the ATM vega is (pretty) constant as volatility increases.
The ATM vega is directly proportional to . In particular, as it gets close to expiry, options have much less vega.
Differentiating with respect to time, we see that
Thus, , which explains why the theta of an option explodes as it gets closer to expiry.
On the week of expiry, you recorded the closing price of the ATM straddle as follows:
|Trading days left||5||4||3||2|
|Price of Straddle||3.35||3.23||3.03||2.73|
What can you conclude is happening?
One might be tempted to differentiate the formula with respect to the stock price, to try and find the delta and the gamma of the options. However, note that the formula is for the price of the straddle when the underlying and the strike are both equal, and thus we are only given the prices when . However, what we really need is the price in terms of , that is independent of . As such, we are unable to take the partial derivatives, because we cannot separate out the effects. In particular, it is not true that
From the Black Scholes formula, we get that
Using Taylor's formula for the normal distribution, for small value of we have
with . Substituting this into the formula of the call, we obtain
The price of the put is equal to the price of the call, and hence