Option replication and exotics journal

[riskarb]

Quote from Trend Fader:

The example i competely made up.. the numbers themselves are kinda irrelevant... i was questioning the logic behind the trade..


--MIKE

Ahh, ok, but it's critical to understand that 1:1 is only possible within one standard deviation. Yes, within one sigma it's plausable, and you understand the advantages of selling exotic premium.

To trade a straddle in exotics requires a synthetic structure; i.e., a short[long] spot//long otm (no)touch. Any atm combination of (no)touches would be immediately triggered. Just an FYI.

 

[Trend Fader]

Quote from riskarb:

Ahh, ok, but it's critical to understand that 1:1 is only possible within one standard deviation. Yes, within one sigma it's plausable, and you understand the advantages of selling exotic premium.

To trade a straddle in exotics requires a synthetic structure; i.e., a short[long] spot//long otm (no)touch. Any atm combination of (no)touches would be immediately triggered. Just an FYI.

So lets take a real example that i have priced via Betonmarkets.com for Gold.

Spot gold is now at 486.. and I can do a no touch Nov. 28 (9 calender days) at 480. The risk to reward is exactly 1:1. So on a payout of $100,000 the bet costs $50,000.

Now lets assume I take this trade and I short gold w/ position size so that each $1 increment is worth around $8,000 dollars. Again I put a stop loss at $492 and i cover and take profit at 480. What I am getting at.. is that the only way I will lose any money is if Gold hits my stop loss level at 492 and then drops back and touches my 480 so I end up losing 50k + 50k. Obviously the best case scenerio would be for gold never to touch 480 and close at say 481.. for a full payout on hedge trade + the no touch trade..

I am trying to understand if my logic is making sense here and if this the way that people trade exotics think... also can this form of short straddle be done via vanilla options maintaining similar risk to reward ?

 

[riskarb]

Right, you've got it, although I don't know where you're getting $800 per point in gold being an adequate hedge on the put no touch. You obviously meant $8,000.

You can see it's a simple matter of solving for the hedge. You'd need to sell 83 futures contracts to adequately hedge the barrier-risk. The risk is then symmetrical; at least to 492. More often than not I'd hedge weakly into the unlimited upside risk. Mention should be made of windfall-gains below the strike, so it's often a good idea to skew your distro-assumptions.

That being stated; I will often trade a no touch put[call] into a market I think will trade strongly lower[higher]. Potential convergence gains if trading near, but not hitting the strike, and windfall gains below if hedged strong.

 

[IV_Trader]

thanks for the link T-F.
the house edge is appx 9% on all touch(no) touch.
here how to calculate it :
1. Create any touch bet with payout of 100$
2. Cost of bet=X
3. Use the same conditions for NO touch bet with payout of 100$
4. Cost of bet=Y
5. Combine X+Y and you get 114$(to win 100)
6. House edge=1-(100/114)=9%

 

[Trend Fader]

Quote from IV_Trader:

thanks for the link T-F.
the house edge is appx 9% on all touch(no) touch.
here how to calculate it :
1. Create any touch bet with payout of 100$
2. Cost of bet=X
3. Use the same conditions for NO touch bet with payout of 100$
4. Cost of bet=Y
5. Combine X+Y and you get 114$(to win 100)
6. House edge=1-(100/114)=9%

Riskarb, is there a similar edge to the otc banks when they price and package these to u?

Should the no touch relative to the touch... have similar payout odds to the bank?

 

[stock777]

Quote from riskarb:

OTB = off the board

lol, knew it was something not related to the ponies.

Funny enough , off the board means the horse ran out of the money (not 1/2 or 3). You sure you're not a closet horseplayer?

 

[riskarb]

Quote from Trend Fader:

Riskarb, is there a similar edge to the otc banks when they price and package these to u?

Should the no touch relative to the touch... have similar payout odds to the bank?

Yes, same as with the expectancy of any market traded. Typical edge paid is in the 5-15% range. FX deals are much tighter due to participation.

 

[riskarb]

Quote from stock777:

lol, knew it was something not related to the ponies.

Funny enough , off the board means the horse ran out of the money (not 1/2 or 3). You sure you're not a closet horseplayer?

I used to go to Arlington Park often with family once they built the new track. I was a b/e player until I hit a long-odds trifecta. I never went to the park after that win, quit while I was ahead.

 

[Trend Fader]

Quote from riskarb:


That being stated; I will often trade a no touch put[call] into a market I think will trade strongly lower[higher]. Potential convergence gains if trading near, but not hitting the strike, and windfall gains below if hedged strong.

This makes sense.. so basically when u have no touch OTM put u are basically bearish because the true play will be on the convergence of trying to get the full payout of both hedge and exotic option.. and u can hedge strong and try to make a profit if the market breaks through the no touch and has a big directional move.. so in this case... the underlying spot is the true play and the exotic is acting a the "hedge"...


--MIKE

 

[riskarb]

Quote from Trend Fader:

This makes sense.. so basically when u have no touch OTM put u are basically bearish because the true play will be on the convergence of trying to get the full payout of both hedge and exotic option.. and u can hedge strong and try to make a profit if the market breaks through the no touch and has a big directional move.. so in this case... the underlying spot is the true play and the exotic is acting a the "hedge"...


--MIKE

Yes, if the position is hedged "strong" [b/e at trade to barrier] it's a bet in the direction of the spot position and the hedge becomes the primary.