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Index constituent weightings and implied volatilities
- Thread starter Grant
- Start date
Quote from IV_Trader:
segv , are you actually trading dispersion (any) ? If yes , do you put position every month ?
I usually end up long dispersion every month, but not as a result of an intentional dispersion trade at the outset. I would probably use swaps instead. Notwithstanding, I know plenty of successful dispersion people, intentional and unintentional.
-segv
Quote from mysticman:
Given the above homework list, I suppose the thread will end now until sometime next year when somebody has read all that. The last paper is nowhere to be found, so why don't you post the pdf?
I will look for it.
On the other hand, suppose one has mastered the use of cointegration and is able to create a basket that has a stationary tracking error. What could you do with that, hypothetically speaking?
Suppose that one creates a basket that closely tracks the S&P 500 index future. When the spread between the basket and the index deviates from its mean by some threshold, one could simultaneously buy (sell) the index future and sell (buy) the constituent basket. The expectation is that the future and the basket will revert to their long term mean (or equilibrium if you like), at which time the trade can be reversed. The trick in employing any convergence strategy is controlling risk. That task is much harder than it sounds, because outlier events happen, and when they do they have a way of annihilating "perfectly" hedged portfolios. Whether you are trading simple dispersion, weighted baskets based on cointegration, crack spreads, or the yield curve the same risk is universal.
-segv
Quote from rosy2:
does anyone trade dispersion profitably between constituents and an index? and if so how big do you have to go to make a decent profit? I assumed desks ended up in a dispersion trade as a sort of hedge.
If you mean by having a complete replication of the index, no I do not. And you are quite correct about the hedge.
-segv
Quote from segv:
Are you running long or short? I assume you are using proxy hedging versus full replication?
-segv
mostly short this year (except for reporting month). Trying to go for full replication , but usually ending up with 80+ % of the weight.
ATM index puts vs. ATM basket puts when short and
Index straddles vs. basket straddles/strangles when long.
Quote from Grant:
Is the implied volatility of the index 22.5%:
A at .25 implied x .75 weighting (= .1875)
+ B at .15 implied x .25 weighting (= .375)
=22.5%?
Quote from Profitaker:
If the correlation was +1 then yes, the index would have a volatility of 22.5%.
No, if the correlation were +1, then the vol would be about 22.9%, not 22.5%.
Take the weighted average of the vars, not the vols. Then take the square root of that to get the basket vol.
Hi all,
I am new to options, so please bear with me. If options are like insurance, and option premiums are like insurance premiums, then selling premium on individual components is like selling insurance and buying the corresponding index option is like buying reinsurance. It would appear that one should be able to turn this into a nice, boring, steady, insurance-selling business. My suspicion is that it's not as easy as that, and it probably has to do with deltas of individual components working against you. The deltas of sold calls with rising underlying prices go up faster than the delta of the bought index call, while falling underlying component prices don't give any benefit beyond the collected premium. Somehow things must be structured such that the scheme above would be a wash (if it were not, then the opposite trade would be an easy, sure source of income). Then I have to conclude that option premium selling is not exactly like insurance premium selling, even at a conceptual level. Either that, or the insurance market is much less efficient than the options market, since insurance is supposed to be a steady, profitable business.
Could the experienced options traders comment/correct/enlighten about this? Thanks.
I am new to options, so please bear with me. If options are like insurance, and option premiums are like insurance premiums, then selling premium on individual components is like selling insurance and buying the corresponding index option is like buying reinsurance. It would appear that one should be able to turn this into a nice, boring, steady, insurance-selling business. My suspicion is that it's not as easy as that, and it probably has to do with deltas of individual components working against you. The deltas of sold calls with rising underlying prices go up faster than the delta of the bought index call, while falling underlying component prices don't give any benefit beyond the collected premium. Somehow things must be structured such that the scheme above would be a wash (if it were not, then the opposite trade would be an easy, sure source of income). Then I have to conclude that option premium selling is not exactly like insurance premium selling, even at a conceptual level. Either that, or the insurance market is much less efficient than the options market, since insurance is supposed to be a steady, profitable business.
Could the experienced options traders comment/correct/enlighten about this? Thanks.
Quote from MTE:
You have pretty much answered your own question, the options market is a lot more efficient or rather fairly priced.
The key component when trading the individual components against the index is the correlation as it has been pointed out in previous posts.
Hmm. So in a perfectly fair and efficient market, the only money an insurer can make is the labor he puts into servicing your insurance needs. And those big insurance firms, which are obviously making more money than that on average (or are they?), are based on some sort of barrier to entry or government intervention or some other source of market distortion. Mind you, I am not disputing what you said. It's just food for thought for me. I somehow had this idea that by aggregating risks, and buying reinsurance at a cheaper rate because of their aggregated, averaged-out risk, the insurance companies were making their money fair and square. Something to look into when/if I have the time. Interesting.