Are spread trades immune to tail risk?

[MrAgi1]

Spread trade involves going long and short 2 different but correlated stocks or futures. It’s also called a pairs trade and futures spread when used in the commodities market.

Question 1:
You are long the S&P’s and short the Dow, weighted according to their volatility. How would a sudden market crash like the pandemic in early 2020 destroy such a trade? Are spread trades a little bit immune to stock market crashes?

Question 2:
Now is it possible to trade options on that spread.
Example: I am long SPY and short IWM (weighted accordingly), and want to buy a call on the SPY-IWM spread. How?

Question 3:
Are there ETFs with primary goal of trying to achieve a spread trade. Example: The ETF is long one index and short another different but correlated index? It could long and short multiple securities.


Note: I am not referring to option vertical spreads like bull calls, bull puts e.t.c
Spread trade is entirely different.

 

[2rosy]

you can trade CSOs, not sure about an off the shelf option on the spread of 2 different indexes. There use to be steepener and flattener ETFs

 

[newwurldmn]

Spread trade involves going long and short 2 different but correlated stocks or futures. It’s also called a pairs trade and futures spread when used in the commodities market.

Question 1:
You are long the S&P’s and short the Dow, weighted according to their volatility. How would a sudden market crash like the pandemic in early 2020 destroy such a trade? Are spread trades a little bit immune to stock market crashes?

Question 2:
Now is it possible to trade options on that spread.
Example: I am long SPY and short IWM (weighted accordingly), and want to buy a call on the SPY-IWM spread. How?

Question 3:
Are there ETFs with primary goal of trying to achieve a spread trade. Example: The ETF is long one index and short another different but correlated index? It could long and short multiple securities.


Note: I am not referring to option vertical spreads like bull calls, bull puts e.t.c
Spread trade is entirely different.

1. mostly yes. but not strictly. for example, until like 2006, there was no tech component to the Dow.
2. Yes, but only as an OTC option traded through a bank. This would require a private banking or prime brokerage relationship.
3. Not to my knowledge.

 

[MrAgi1]

you can trade CSOs, not sure about an off the shelf option on the spread of 2 different indexes. There use to be steepener and flattener ETFs

I assume you mean calendar spread options offered by the CME? If so, are those tight or at-least with reasonable bid-ask spreads?

Never seen CSOs talked about anywhere.

 

[2rosy]

I assume you mean calendar spread options offered by the CME? If so, are those tight or at-least with reasonable bid-ask spreads?

Never seen CSOs talked about anywhere.

yes, but I am more familiar with the energy CSOs traded on ice through chat. I don't think retail is involved

 

[trade4succes]

Spread trade involves going long and short 2 different but correlated stocks or futures. It’s also called a pairs trade and futures spread when used in the commodities market.

Question 1:
You are long the S&P’s and short the Dow, weighted according to their volatility. How would a sudden market crash like the pandemic in early 2020 destroy such a trade? Are spread trades a little bit immune to stock market crashes?

Question 2:
Now is it possible to trade options on that spread.
Example: I am long SPY and short IWM (weighted accordingly), and want to buy a call on the SPY-IWM spread. How?

Question 3:
Are there ETFs with primary goal of trying to achieve a spread trade. Example: The ETF is long one index and short another different but correlated index? It could long and short multiple securities.


Note: I am not referring to option vertical spreads like bull calls, bull puts e.t.c
Spread trade is entirely different.

Question 2: Probably you can replicate such a portfolio by some active repositioning, however the math wouldn't be trivial I can imagine. I am interested in this as well.

 

[newwurldmn]

Question 2: Probably you can replicate such a portfolio by some active repositioning, however the math wouldn't be trivial I can imagine. I am interested in this as well.

I don’t believe you can replicate an outperformance option with just vanilla options or dynamic hedging.

 

[TrAndy2022]

1. Yes immune to some extent, because you are market neutral (but the spread can diverge too, so you need to take care of your leverage you are going into any spread trade (better to backtest this))
2. Yes possible via options, but this is advanced. You can have long call and long put as "spread" or if you want to replicate futures you also need to have short option position on both sides, but not recommended to do it via options, just go with futures then.
3. Clearly no (as I am not aware of any spread ETF built in one single ETF).

 

[Real Money]

A couple things on this.

The big banks have OTC desks for all this stuff. They're registered as FCM-BD-SD which means they can trade all markets, and have privately managed risk controls. This means the bank clients are not using standard exchange margining (TIMS, REG-T, SPAN, etc.), and they have access to all manner of OTC products, exotics.

So, for something like SPY-IWM, the cheapest leverage is available from D1 desks at these banks (Total Return Swap), or special "made-to-order" products involving D1 and other types of forward/term/optionable features.

I'm not sure but I would imagine you could lever the shit out of this spread with cash settled index options.

For normal traders, you can most efficiently lever an index spread using futures, but you can also trade these spreads via ETF during the cash session. If you have enough funds you can hold long/short positions in ETFs and hedge with futures.

You can trade two indexes against each other, but you can also trade baskets and sectors against one another. Hedged baskets, basket/sector ETF, index vs basket, sector vs index, etc.

 

[trade4succes]

1. mostly yes. but not strictly. for example, until like 2006, there was no tech component to the Dow.
2. Yes, but only as an OTC option traded through a bank. This would require a private banking or prime brokerage relationship.
3. Not to my knowledge.

regarding 2.: If a bank can sell you such a product, they will (very likely) hedge it themselves by using a combination of exchange traded (or at least simpler, more common) products and dynamics. As I understand, banks typically don't trade against their customers anymore since Dodd-Frank (sp?) anymore, but rather make money from adding a fixed premium on a hedged product. I can imagine that's what quants at the trading desks are for, to find out how to hedge these exotic products.

1. Yes immune to some extent, because you are market neutral (but the spread can diverge too, so you need to take care of your leverage you are going into any spread trade (better to backtest this))
2. Yes possible via options, but this is advanced. You can have long call and long put as "spread" or if you want to replicate futures you also need to have short option position on both sides, but not recommended to do it via options, just go with futures then.
3. Clearly no (as I am not aware of any spread ETF built in one single ETF).

regarding 2.: Advanced yes, I wonder what would be needed to solve the puzzle. To collect my initial thoughts: What OP wants is a products that acts like buying an option on a directional product, but now on a pair. So fixed downside risk, open-ended profit opportunity. First thing that comes to mind is buying a call on the long leg, and buying a put on the short leg, as you say. As long as the mean of both products doesn't move much, that will approximate the desired behavior, but it feels a bit off in general (because of asymmetry), and especially if the mean starts moving away from where it was at Time_0.