Quote from mynd66:
Sounds very interesting and is starting to make more sense. So let me get this strait, you first recognize what you deem an "anomaly" in the vegas within a range of strikes. Sell the strikes where vega is relatively high and buy the strikes with low vega. Is this a sort of arbitrage?
It's only an arbitrage if the options you're buying and selling against each other are at the same strike - a conversion or reversal. Otherwise it's a spread, not an arbitrage
Since it is a play on vega you hedge against delta/gamma. If in fact as in this scenario you are short the further OTM's doesn't theta create a problem? Since theta's value is greater ATM, wouldn't the position create a discrepancy where theta will have a greater negative effect on the long calls than it would positive on the short?
I'm talking about doing this spread at a ratio that makes you gamma neutral, vega neutral, and theta neutral. In a nutshell, premium neutral. So you would be short more far otm calls than you are long atm calls.
As you seem to understand well, this would make you short premium as the underlying rises. Since in the example I gave, iv would drop as the underlying rises, that's good. The underlying (the S&P) would go up, you would get short premium - including of course short vega - iv would drop and you would make money. It's also interesting to note that with this position, if iv drops first, you would get long deltas, and as the underlying went up you would also make money.
But then again if this is a play on vega it should not be held long enough for theta to have a great effect. Is that the case? Is vega actually predictable enough where it has a reliable mean reversion aspect to it?
Okay, here's where we need again to resolve your confusion over the point of delta-neutral, premium-neutral option trading. The point of such trading is to simply NOT LOSE MONEY ON CHANGES IN THE UNDERLYING, CHANGES IN OVERALL IV, OR THE PASSAGE OF TIME while you are waiting for some volatility spread you have put on to work.
Let me give you some examples from when I was a local in the T-bond options pit, and always maintained my position delta and premium neutral.
As a local (the futures exchanges' term for market maker), I was buying the bid and selling the offer. That was one edge. Since I was trading the back months, most of the options were quite illiquid.
I'll give you a specific scenario. Let's say a broker comes in and asks for a market on the 100 calls. He doesn't say if he wants to buy or sell them, because then we could adjust our markets accordingly. So we give the broker a market of .50 bid at .52. He sells me 100 at .50.
Now, if a second later another broker came in BUYING the 100 calls, I could sell them at the offer - .52 - and make a 200-tick profit.
But these options were not that liquid. It might be a week or a month before somebody would come in wanting to buy those 100 calls. In the meantime, while I was holding those 100 calls in my inventory, the last thing I wanted was to be exposed to delta risk. So the moment I bought those 100 calls, I would turn to the futures pit, signal my broker, and sell futures to become delta neutral.
So far so good. But I'm still long premium. I'm still exposed to theta risk, gamma risk, and vega risk. So now I'm interested in selling premium to become premium neutral. If I can't sell it at the 100 strike, I'll look to sell it somewhere else.
Let's say a broker now comes in looking for a market in the 102 calls. The locals give him a market of .30 bid at .33. I really want to sell some premium, so I offer them at .32. The broker buys a hundred. I immediately turn to the futures pit and buy futures to make myself delta neutral again.
Now I'm long 100 100 calls, short 100 102 calls, and short futures at a ratio that makes me delta neutral. The futures are at 101 - halfway between my long 100 calls and my short 102 calls - so I'm premium neutral as well.
Later that day, let's say that iv is down. But the iv relationship between the 100 calls and the 102 calls hasn't changed, so I have not made or lost money. I'm just waiting for someone to come in wanting to buy the 100 calls so I can sell them at the offer, and someone wanting to sell the 102 calls so I can buy them back at the bid. If I do so, I'll realize a profit.
So basically, the job of a market maker is to buy wholesale and sell retail, while neutralizing all the other extraneous factors such as movement in the underlying, movement of IV, and the passage of time.
In real life, you don't stop after you've bought the 100 calls and sold the 102 calls. You keep on making markets all day long. For days at a time, all your trades may be opening positions. So your total position grows really fast, and before you know it you add up all your longs and shorts and it comes out to 5000 or 6000 options, against several hundred long or short futures.
That's why you have to know your greeks cold - it's the only way you could possibly manage such a position. Without them you would have no idea where you were.
As a retail trader you can't buy the bid and sell the offer. But what you can do is become very familiar with all the IV relationships - strike to strike (the skew), month to month, etc. Then, when those get way out of line, you can buy the cheap one and sell the expensive one at a ratio that gets you premium neutral, and buy or sell the underlying at a ratio that makes you delta neutral. When the IV relationship comes back into line, the idea is to take off your spread and realize your profit.
