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Short the straddle when implied beats your view

Asked at Akuna, Jane Street

optionsexpected-movestraddle

A stock trades at \100intoearnings.Theat−the−moneyweeklystraddlecostsinto earnings. The at-the-money weekly straddle costs$5,sothemarketimpliesa, so the market implies a 5%move.Yourownmodelforecaststherealizedmovewillaverageonlymove. Your own model forecasts the realized move will average only$3$.

What is the trade, roughly what is the edge, and what are the main risks that make this less free than it looks?

Show a hint

The straddle buyer pays \5andcollectstherealizedand collects the realized|movemove|$. If you think that realized move is smaller than the price, which side do you want?

Your answer

This one is open-ended. Work it through, then check your reasoning against the full solution.

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