Betting on unflattening of the ATM IV curve

[morganpbrown]

The information here is golden. I really appreciate the expertise dump, which you probably can't get in a book. I know they're paying you all the big bucks to teach the trade to perfect strangers.

Question about signs on theta/gamma. negative theta (bad) / negative gamma (bad) = positive theta/gamma (seemingly good but presumably bad?). Do you handle interpretation of the four cases (+/+, -/+, +/-, -/-) independently, or is there a unified interpretation?

 

[jamesbp]

@jamesbp sorry to be dense, but would you mind clarifying this formula for net normalized vega?

I think you've got it ...

To illustrate the point, I monitor both Raw Vega and TimeWeighted Vega.

If I compare ATM straddles across 6 expiries, Nov21 - Jun22, you can see that:
... the Raw Vega ranges from $112-$447 [ RED ARROW ] but
... the Time Weighted Vega ranges from $112-$117 [BLUE ARROW]

 

[MrMuppet]

Thank you MrMuppet for this concrete example. Maybe I got this wrong, but I thought when the move comes in, the IV for both front and back months should increase, not reduce? I'm thinking in the case of an index and it drops suddenly. I agree the skew should flatten.

Also, I'm curious how you would manage the vega risk in this example. I understand you construct it to be vega neutral at inception. But there is still the risk that front and back month IVs do not change according to the ratio (sqrt time or other), and it will make the calendar not vega neutral any more.

Here's the thing: you are right under certain circumstances. When the move is a surprise, IV will skyrocket. Look at BBBY. Where calendars are good is when the market anticipates a move and IV inflates BEFORE the market moves.

Thanks. I originally had this formula in my Franken-sheet, but the normalized vega values so often seemed to be zero, that I thought I had an error.

If I want to understand the sensitivity of a complex option position to volatility, is this normalized vega "the answer", or is it more of a "it depends"?

You want to normalize vega to the maturity that has most liquidity, because this is usually the chain that is priced optimally. So if the most volume/most open interest chain has 52DTE, you want to normalize the curve to 52DTE. So yes, it depends.

When you use option combinations for ‘directional’ trading, isn’t it ‘better’ to shift the strike you are buying more atm? When your view is correct you lose less delta on your long side.

The diagonal pays more (absolute) profit per combo IF it drops since you lose less delta on your longs calls. This is of coure offset to some extend having less delta when it rises (you are wrong).

You're totally free in the way you construct your position. For me, when I have edge in vol, I want to exploit that. I don't have edge in spot. So even if I have no clue about the resolving move, I'd take the trade in the direction that has most vol edge. When spot is 50/50 but my payout is 10:1 I really don't care about the spot move as I'm probably already massively ahead after 10 trades when I cash in on two and lose on the rest

 

[Magic]

The sweet spot is usually when your weighted vega is zero, your theta is zero and you get a lot of gamma basically for free...and then the market nukes

Long calendars are really tricky

Depends on the situation but I also like being able to lean short on rt time vega and/or long theta against a pocket of cheap gamma. Me and a friend have a trade on like that right now. RV coming in a bit low (so far) and it’s great to be able to collect the risk bid on vol for a while without having to manage the negative gearing that typically comes with it.

Great feeling trading pockets of real edge vs. mucking around in a fairly priced chain, but most of ET will never see the former and most don’t even get the difference. Thinking like MrMuppet and spreading off risks to isolate a tailwind will maybe help you find one here or there. These recent posts are gems for the neophyte.

 

[MrMuppet]

Depends on the situation but I also like being able to lean short on rt time vega and/or long theta against a pocket of cheap gamma. Me and a friend have a trade on like that right now. RV coming in a bit low (so far) and it’s great to be able to collect the risk bid on vol for a while without having to manage the negative gearing that typically comes with it.

Great feeling trading pockets of real edge vs. mucking around in a fairly priced chain, but most of ET will never see the former and most don’t even get the difference. Thinking like MrMuppet and spreading off risks to isolate a tailwind will maybe help you find one here or there. These recent posts are gems for the neophyte.

of course you're free to collect carry vs RV and flatten your gamma position with a calendar. It's the vol edge that makes money, no matter how you structure the trade.

 

[Magic]

Yeah, I agree with you in case I was unclear. It's a relative value trade I mentioned, not just a calendar. If you have edge you can express it where ever you choose. Extra gamma with flat carry or vice versa. A fairly priced option chain has expected PnL close to zero and the structures just shift the distribution around, which is a hard thing to grasp for some of the new guys it seems.

First thing needed to make good PnL is actually selling something rich vs. the replication, or across the term structure, or across tightly correlated assets, etc. Then we can structure the PnL distribution against the risks, goals, and capital constraints of the scenario.

 

[MrMuppet]

Yeah, I agree with you in case I was unclear. It's a relative value trade I mentioned, not just a calendar. If you have edge you can express it where ever you choose. Extra gamma with flat carry or vice versa. A fairly priced option chain has expected PnL close to zero and the structures just shift the distribution around, which is a hard thing to grasp for some of the new guys it seems.

First thing needed to make good PnL is actually selling something rich vs. the replication, or across the term structure, or across tightly correlated assets, etc. Then we can structure the PnL distribution against the risks, goals, and capital constraints of the scenario.

This is probably the best written summary of what trading is all about!

 

[Zwaen]

Yeah, I agree with you in case I was unclear. It's a relative value trade I mentioned, not just a calendar. If you have edge you can express it where ever you choose. Extra gamma with flat carry or vice versa. A fairly priced option chain has expected PnL close to zero and the structures just shift the distribution around, which is a hard thing to grasp for some of the new guys it seems.

First thing needed to make good PnL is actually selling something rich vs. the replication, or across the term structure, or across tightly correlated assets, etc. Then we can structure the PnL distribution against the risks, goals, and capital constraints of the scenario.

It certainly is always best to understand the underlying concepts since form will change over time while concepts and/or processes often last longer then it's form in present state.

When you (at least i did) start out you tend to think a certain combination contains edge, so you spend (too) much time thinking you should use a 2-3-1 or a 1-2-1 butterfly for example. At least I never found something herein, but this changed when I viewed options/combinations not in isolation, but more in a strategic way. For example, setting them up over series depending upon certain movement of the underlying. These things are difficult to backtest, which is probably a blessing.

 

[qlai]

If you have edge you can express it where ever you choose.

Would you mind sharing where do you think this edge comes from? In other words, who’s creating these inefficiencies you are exploiting? I was under impression that options are very efficiently priced and by the brightest firms. Ate you competing against them or do you find yourself joining them (against buy-side flows that create these inefficiencies)? Who’s on the other side of your trade, if it’s not the MMs?

 

[Magic]

Would you mind sharing where do you think this edge comes from? In other words, who’s creating these inefficiencies you are exploiting? I was under impression that options are very efficiently priced and by the brightest firms. Ate you competing against them or do you find yourself joining them (against buy-side flows that create these inefficiencies)? Who’s on the other side of your trade, if it’s not the MMs?

Sometimes it is the MMs. In fringe markets they still make mistakes sometimes, or seemingly a mistake from being at an information disadvantage to you. Or it could be some trader who is loaded with edge and wants to offload some risk somewhere and he just finds the cheapest way to do it despite a slight inefficiency. At the end of the day there’s usually going to be some price insensitivity on the other side of a good trade but it might be for very rational reasons. It’s interesting to spend a little time on philosophy but it doesn’t really matter to my bottom line.