Accuracy of the Expected Move (Part 2)

I previously reprinted a post from a trading forum along with my response from last year.

The original poster says the ATM straddle is a poor estimate for the Expected Move. What irked me was that he provided no data to support this claim. Had he done a large number of trades? Had he studied it? In case he did, I asked in my response who had done the backtesting on it. He did not respond.

Tasty Trade offers a specific definition of Expected Move: 85% of the value of the front month at-the-money (ATM) straddle OR the arithmetic mean of ATM straddle and the nearest OTM strangle. How do they know that is what people expect, though? They really don’t and they really can’t. It’s not like they surveyed a large sample of people to find out what size move is expected.

A deeper understanding of options does offer some association between the name and the definition. The straddle/strangle will profit on a move in either direction greater than its original price. If traders, in general, think the move will be larger (smaller) than the cost of the straddle/strangle then they will buy (sell) it. The net result of these supply/demand pressures will be the price. Theoretically speaking, then, one could say it reflects what size move traders are expecting.

In the past, I heard more discussion about “implied move.” I have no reservations about the word implied. “Expected” is potentially a misnomer because it connotes some intelligence is explicitly regarding this as likely to happen. We don’t know why traders are buying or selling those options, though, or how many of them even have anything to do with the straddle/strangle itself: they may be components of different positions.

Going back to the top, whether the Expected Move has any predictive value is a completely different question that lends itself to backtesting. Tasty Trade has since done some backtesting to suggest the actual move is usually smaller than Expected. This would be an instance of “herd instinct” and why it might pay to be contrarian.