Questions from an options noob

Quote from TskTsk:

Thanks newwurldmn, this answers a lot of my questions.

However, regarding #5, say I want to replicate a variance swap. What I'll do is basically short straddles all over the place, at equidistant moneyness, say $5 or so between each straddle. Now here's the thing. The straddle I short ATM is going to earn me an extrinsic value of for example $5 in total. But the straddles I short ITM/OTM, are going to earn me extrinsic values of less than $5, and it gets lesser and lesser the more in/out of the money the short straddle is. And if price now moves to one of my deep short straddles, and it becomes ATM, it's extrinsic value is going to increase beyond the initial extrinsic value I shorted it at. Won't this give me a disadvantage? Theta will obviously also increase as it comes closer to ATM, but as far as I see, that theta increase won't benefit me in any way, because I don't have enough extrinsic value to realize the theta. People who shorted it while it was ATM on the other hand, have enough extrinsic value to realize the theta.

Or am I overthinking it?
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First of all, no need in trading straddles. Just trade the out of the money option (puts on the downside, calls on the upside).

Secondly you are right. If the spot moves fast, you will lose money. But at this point you need to look at the portfolio as a soup of risk instead of each individual option.

Suppose the stock moves slowly down (so you are able to stay constantly delta flat). What will happen is that your atm options will be decaying a lot and they will also be becoming out of the money options. At the same time your out of the money options are becoming atm options. You can view these as offsetting.

If the underlying moves quickly down then you will have delta/gamma issues like you would in a single strike short straddle scenario.

FYI - This is very tough to implement in real life. It's hard for even banks to synthetically create variance swaps.
 
Quote from newwurldmn:

First of all, no need in trading straddles. Just trade the out of the money option (puts on the downside, calls on the upside).

Secondly you are right. If the spot moves fast, you will lose money. But at this point you need to look at the portfolio as a soup of risk instead of each individual option.

Suppose the stock moves slowly down (so you are able to stay constantly delta flat). What will happen is that your atm options will be decaying a lot and they will also be becoming out of the money options. At the same time your out of the money options are becoming atm options. You can view these as offsetting.

If the underlying moves quickly down then you will have delta/gamma issues like you would in a single strike short straddle scenario.

FYI - This is very tough to implement in real life. It's hard for even banks to synthetically create variance swaps.
More...

Thanks for your answer,

So straddles aren't needed, just short upside calls and dowside puts basically. Good to know. So one simple question: Say I short an OTM call, stock moves up, and it becomes ATM. I've lost money. But I was also short a put further down, which was ATM, but is now OTM. So I've made money on this one. Overall, I'm neutral. (minus the required delta hedges and vega exposure). Is this correct? Is it also correct that gamma / theta exposure is "smoothened" out, because one option gains gamma / theta while the other loses?

If all is correct, I assume the same principle can be applied to straddles, no?

Also aware that synthetically creating var swaps is hard, but all I'm looking for is smoothing out the gamma / theta accross several strikes. This is vital IMO if you're trying to make money on theta. Because as said, realized theta, unlike realized gamma, is a wild beast. If you're short just one ATM straddle, your theta curve will be uneven. As UL fluctuates intraday, your theta can vary from say 0.15 to 0.10. So at the end of 24hrs, how much realized theta profit do you have? 0.15? 0.10? 0.12? Who knows...
 
Quote from TskTsk:

Thanks for your answer,

So straddles aren't needed, just short upside calls and dowside puts basically. Good to know. So one simple question: Say I short an OTM call, stock moves up, and it becomes ATM. I've lost money. But I was also short a put further down, which was ATM, but is now OTM. So I've made money on this one. Overall, I'm neutral. (minus the required delta hedges and vega exposure). Is this correct? Is it also correct that gamma / theta exposure is "smoothened" out, because one option gains gamma / theta while the other loses?

If all is correct, I assume the same principle can be applied to straddles, no?

Also aware that synthetically creating var swaps is hard, but all I'm looking for is smoothing out the gamma / theta accross several strikes. This is vital IMO if you're trying to make money on theta. Because as said, realized theta, unlike realized gamma, is a wild beast. If you're short just one ATM straddle, your theta curve will be uneven. As UL fluctuates intraday, your theta can vary from say 0.15 to 0.10. So at the end of 24hrs, how much realized theta profit do you have? 0.15? 0.10? 0.12? Who knows...
More...

You are right. Straddles would be the same as the out of the money options except that in the money options tend to be less liquid than their out of the money counterparts.

I know what you mean. Theta pnl mashes with vega pnl and delta/gamma pnl. It's hard to say "I made x" on theta today in practice. This is especially true as often your theta is less than the width of bid offer. What I find is that overtime you see you are up some money in the option. it's good to manage your gamma/theta and I would rebalance it as needed when the numbers get too big. Trading a bunch of contracts now will be costly and soak up a lot of your capital. Not to mention, a pain in the ass to unwind. Trade the straddle plus say 1 OTM option. Then reduce as your gamma/theta profile changes.
 
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