Diagonal Spread VS Ratio Spread VS Dynamic Delta Hedge

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Viperace

Fellow Option Traders,

Supposed I have a view on Implied vol increasing or decreasing, and I want to take this bet.

What is the best way to play it ?
1. According to (a simple) example E. Sinclair book, he mentioned long/short call/put + delta hedging dynamically as it move beyond the band.
2. Some sites suggests doing a diagonal spread ( long ATM far option, short OTM near option), plus some underlying. This is to achieve Gamma/Delta neutral and hence just wait
3. Other sites suggests doing ratio calendar spread. I supposed also delta/gamma neutral.


Now, I believe each must have their merit or else people won't be doing it.
Do you play any of these? If yes, what is their strength/weakness?
 
1) The option and discrete/dynamic hedge becomes a synthetic straddle as you approach the strike, and a D1 position as you trade away (from the strike). The var will relate to your PNL as well as your hedging efficiency. Are you a good stock trader?

2) Better play -- better treatment under RegT and less D1 size.

3) You can't run gamma-neutral w/o being long vega.
 
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If your guess as to over- or under-priced vol is correct (realized less/greater than entry implied), you choose your 'bands' correctly, and if transaction frictions are acceptable, then you have a likely chance of a positive replication error. But to be sure, your risk tolerance needs to be path independent to prevail unless your vol reversion occurs straight away.

The diagonal can be a great trade, but there are more variables involved than in your first example to say confidently 'yes, this will be a great way to play your hunch.' At the very least, you've got vol in more than one expiration series to contend with.

The ratio time spread has the same challenges as the diagonal. Depending on the circumstances, the vol differences can run havoc with the best laid plans.

Good luck. Consider running a journal here. You'll get stupid comments along the way, but you'll get some reasonable ones as well. There are some smart boys and girls hiding out here.
 
Thank you all. It is a hit on the head.

Horizontal spread exposes the Vol term structure risk! Basically, short-date IV and longer-date IV is not perfectly correlated. Now, I got one more

4) Straddle/Strangle + Delta Neutral


Hi Convexx,
You said can't run Gamma neutral w/o long Vega. I think it is possible, it is mix-and-match problem by combining different strike/maturity. Combination of Long/Short short-date/long-date option can create different sign of Gamma/Vega exposure, (I recall Taleb's book showing a table on this). Unless you are saying this is not feasible dynamically? Please enlighten.
 
If I thought implied vols would rise (or fall), I would trade either 1) or 4).
You can definitely be gamma neutral but have a vega position.
 
I believe implied vols will go up so I trade 2). I am correct and implied vols goes up (everything else stays constant). If the out the money implied vols goes up significantly more that at the money vols, I will not make money.

Same logic applies to 3).

If you don't hedge deltas, they will probably become the biggest risk (bigger than vega, gamma and any other greek). The question you need to have answered before you trade is how often will you hedge.
 
Vega is always mis-priced so anything 2 months out is pot luck- I've done every type of calendar,and don't like 'em personally as they frequently disappoint. Curiously I think Tasty Trade's assessment of trading at about 45 days to expiry is sound. PIN risk is a whole other area. Enjoy- I still love trading after 15 years
 
Windlesham1 said:
Vega is always mis-priced so anything 2 months out is pot luck- I've done every type of calendar,and don't like 'em personally as they frequently disappoint. Curiously I think Tasty Trade's assessment of trading at about 45 days to expiry is sound. PIN risk is a whole other area. Enjoy- I still love trading after 15 years
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Vol is *always* mispriced? You must be one of the richest men in the world.

Why do calendar's disspoint you?

Why would you be listening to TastyTrade after 15 years of arbitraging all the mispriced implieds?
 
Viperace said:
Fellow Option Traders,

Supposed I have a view on Implied vol increasing or decreasing, and I want to take this bet.

What is the best way to play it ?
1. According to (a simple) example E. Sinclair book, he mentioned long/short call/put + delta hedging dynamically as it move beyond the band.
2. Some sites suggests doing a diagonal spread ( long ATM far option, short OTM near option), plus some underlying. This is to achieve Gamma/Delta neutral and hence just wait
3. Other sites suggests doing ratio calendar spread. I supposed also delta/gamma neutral.


Now, I believe each must have their merit or else people won't be doing it.
Do you play any of these? If yes, what is their strength/weakness?
More...

Each structure has its merits. It comes down to your view of implied vol. Some will express that view better than others. My largest trade right now is short outright vol (atm straddles) in Jan15 on a single stock. I believe there is 10 vols in it (either in carry or in vega). Any other structure would reduce my expected pnl as the term structure is flat and I would like to take the gamma/theta risk.

If you do #2, you will be betting that the term structure will steepen (front drop more than the back on a root time basis) and you have a view on how the skew will pan out.

If you do #3, you will often find yourself with significant other risks (gamma profile changing with spot, etc). This can be useful if you have the view that the term structure will move outside of root time vol.

In the end if you are trading for implied vols then you have to be very precise in the structure you trade. Most options will owe most of their vega pnl on the same risk factors. So any spreads will require you to have a view on the basis between the different options. And when you are trading spreads for vega (which generally amounts to pennies or nickels on the option premium) that basis will be a significant driver.

So what I am saying, unless you have an explicit view and you can take the margin, trade straddles and delta hedge.

Trade the spread if you either have the view that fits that spread (skew, term structure, etc) or that those risk factors are a small component of your expected pnl.
 
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