Question about index arbitrage strategy

E

Erich95746

Hello !
My question regards the strategy of the fund described below:

Fairfield Sentry is a fund that employs a sophisticated statistical index arbitrage strategy known as a "zero-beta" or a non-market dependent strategy. Profits are earned on inefficiencies in the pricing of highly liquid index options, in this case, the S&P 100. The strategy has three distinct components. First, the manager buys a basket of 25-35 individual stocks, providing a close proxy to an index (again in this case, the S&P 100). Next, he then hedges out the downward risk of the stock holdings by simultaneously selling out of the money index call options and then buying out of the money (or at the money) index put options. The sale of options also increases the return through premiums earned. Generally, this strategy does not make use of leverage.

Please, can somebody explain in detail how this strategy works or post some useful links. I have done some research on the web, but didn’t find any useful resources. The strategy consists of a long + a synthetic short position, but what I don’t understand is how it generates its profits.

Many thanks in advance
Bernhard:confused:
 
Here is my take on this strategy. I might be way off so anyone can to counter a better explanation, I welcome it.

Scene 1: sold call is closer and bought put is further out so position really is nothing but a buy write protected by a put. Returns are enhanced with buy-write and since closer months trade at higher vol than back months extra juice there.

Scene 2: Could be a dividend play on some of the long stocks complemented with scenario 1.

Scene 3: Some form of dispersion trades where one is long options on compont stocks against short premium on indexes. For in depth go to ivolatility.com

Any better angles?
 
One thing to realize is that there will be tracking error since the portfolio manager will not own the entire index that he/she will be writing options against.

Essentially the portfolio manager is removing the tails of the probability distribution with this strategy. He/she is hedged from severe moves down while at the same time he/she has capped the returns to the upside. Picture the distribution as the bell shaped curve without the tails. Thus, the portfolio manager wants the market to remain pretty much stable so he/she can outperform the underlying index.
 
I don't see how buy-writes amount to index arb. I mean, I understand the strategy and it's relationship to the S&P 100, but I don't think that the proper name for it is index arb.

I would think a more profitable strategy would be purely selling OTM index options - short straddles. Risk would be even lower, since you could sell further OTM options than the OTM calls in the above strategy for the same profit, and these further out options will sport higher thetas.
 
That's a nice strategy for someone who
is conservative and has BIG money.

It surprises me that the strategy is applica-
ble on an amount of 3 billion dollars...
 
I don't see how this is profitable in relation to the risk. Assuming that an edge can be gained I guess it would be lost in the spead of the OEX options.
Besides, of all the options there are the OEX are the most closely watched and priced. I traded those suckers for 2 years and I could never find a significant edge.
Anyway, you would have to be the whole index to make it really work (I think someone already said that).

Cheers
:cool:
 
Personally, I would have a hard time believing there is a significant edge as well...The OEX spreads have grown larger and larger over the years...My feeling is that the OEX was THE index market before the QQQ's and before the proliferation of direct hedging one to one on the index components...There was a time when that OEX was trading at 1/8 spreads...It was a great trading vehicle...Of course, that was also before you had IB with their cheap commissions...
 
Actually, another thought on the subject...If I were so inclined and had the patience and discipline to execute a specific strategy only a few times a year..The one that I would execute would be a simple volatility play...Just buy and buy and buy OEX options in the front and deferred months when the implied volatility traded within x percent of its 52 week lows...keep rolling them out following any losses in the front month...Kinda like Nassim taleb's strategy but with a specific volatility input...

You could also just trade seasonal tendencies, like loading up on OTM puts in the late summer when volatility contracts for the seasonal sell-off in Sept-Oct...that has been a sure play for a number of years...
 
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