"risk-free" capturing of skew...?

[thepolarbear]

Please help me understand the flaws in this strategy.

Let's say there is a significant amount of put skew. Underlying is currently at $100. $95 Put is trading with IV of 20. $105 Put is trading with IV of 10.

So you put on a bear vertical spread and delta-hedge with the underlying to remain delta-neutral until expiration. Wouldn't this mean you are guaranteed to capture the skew? The realized vol between the time you open the position and expiration has to be 1 number, so you are guaranteed to make exactly the difference between the 2 IVs from your vega position?

One problem I see is not being gamma neutral so you are exposed to gap moves / jumps, but is there something else I have missed?

 

[cdcaveman]

Quote from thepolarbear:

Please help me understand the flaws in this strategy.

Let's say there is a significant amount of put skew. Underlying is currently at $100. $95 Put is trading with IV of 20. $105 Put is trading with IV of 10.

So you put on a bear vertical spread and delta-hedge with the underlying to remain delta-neutral until expiration. Wouldn't this mean you are guaranteed to capture the skew? The realized vol between the time you open the position and expiration has to be 1 number, so you are guaranteed to make exactly the difference between the 2 IVs from your vega position?

One problem I see is not being gamma neutral so you are exposed to gap moves / jumps, but is there something else I have missed?

umm.. the 105 is otm at 10, and the itm 95 is at 20... isn't it usually the other way around.. the otm's have higher implieds.. at least depending on the instrument..

my first thought is.. the itm doesn't always stay in the money.. its basic strike risk senario.. all of a sudden all the strkes are out of the money.. and your subject to hedge frequency speculation...

a delta hedged risk reversal is typically how you extract skew .. at least thats from what i've read.. never done it..

 

[thepolarbear]

Quote from cdcaveman:

umm.. the 105 is otm at 10, and the itm 95 is at 20... isn't it usually the other way around.. the otm's have higher implieds.. at least depending on the instrument..

I think you misread? My example uses puts, so the $95 Put is OTM and the $105 Put is ITM

 

[cdcaveman]

Quote from thepolarbear:

I think you misread? My example uses puts, so the $95 Put is OTM and the $105 Put is ITM

haha sorry i was about to say.. i was just crossing my eyes and making werid faces at my friends.. looks like it had an effect on the reading of your post.. anyway..

so if it is agreed that the itm put will trade at a similar implied as the call.. you could then theoretically put on a risk reversal to extract the skew.. liquidity is of course a factor.. and the changing skew profile over the changing time of the trade.. ie sticky delta/strike ... i'm only reading about this.. i'm sure theres guys that have practice with this.. but buying an otm call and selling an otm put.. or vice versa is a way you extract it.. because your otm call is going to trade at the same implieds as your described itm put.. i hope other people say stuff.. i'm very interested in this sort of thing..
http://www.elitetrader.com/vb/showthread.php?threadid=228621

 

[thepolarbear]

ah ok a delta-hedged risk reversal is exactly what I am looking for. I used the vertical spread example because I didn't know if there was a term for buy OTM call, sell OTM put.

my question still stands though: assuming you can delta-hedge perfectly and continuously to expiration (so you are not exposed to short-term fluctuations in skew) are you guaranteed to make money from the skew at expiration?

 

[cdcaveman]

Quote from thepolarbear:

ah ok a delta-hedged risk reversal is exactly what I am looking for. I used the vertical spread example because I didn't know if there was a term for buy OTM call, sell OTM put.

my question still stands though: assuming you can delta-hedge perfectly and continuously to expiration (so you are not exposed to short-term fluctuations in skew) are you guaranteed to make money from the skew at expiration?

i urge you to read the thread i posted.. njrookie is after the same thing you are.. and is discussing it in depth with atticus. ivtrader, sle, newworldmn.. people i know KNOW... so i'd read the post.. research a bit ..

 

[sle]

Quote from thepolarbear:
my question still stands though: assuming you can delta-hedge perfectly and continuously to expiration (so you are not exposed to short-term fluctuations in skew) are you guaranteed to make money from the skew at expiration?

Of course the answer is 'NO' - P&L for a delta hedged option position is inherently stochastic. Even if you have predicted the realized volatility correctly, the path dependent nature of the beast can make it a losing trade, more so in a risk reversal where you have multiple strikes. I just came back from a fund-raising event, so not fully coherent (read 'piss drunk'), but I recall there was a thread about trading the skew that had a lot of useless details provided by yours truly.

 

[cdcaveman]

Quote from sle:

Of course the answer is 'NO' - P&L for the delta hedged option position is inherently stochastic. Even if you have predicted the realized volatility correctly, the path dependent nature of the beast can make it a losing trade, more so in a risk reversal where you have multiple strikes. I just came back from a fund-raising event, so not fully coherent (read 'piss drunk'), but I recall there was a thread about trading the skew that had a lot of useless details provided by yours truly.

sle.. maybe some good information will pour out.. i posted the thread.. njrookie was theorizing trying to extract skew premium... and everyone of you guys was sort of against the idea because of its associative costs..

 

[kapw7]

There is this Neuberger paper (not finalised yet):
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1571700

where a "skew swap" is introduced in analogy to the variance swap.
I cannot make any comments on the proof but they come up with equations to calculate both (model free) implied skew and realised skew which look simple enough to even do in Excel.

They also give a graph of the skew risk premium for the S&P

It seems practically impossible to replicate their skew swap contract (I might be wrong) and they claim their equations are robust to jumps/non continous trading

Anyone (sle et al) have any more useful comments on its practical value (or not)?

 

[thepolarbear]

Quote from sle:

Of course the answer is 'NO' - P&L for a delta hedged option position is inherently stochastic. Even if you have predicted the realized volatility correctly, the path dependent nature of the beast can make it a losing trade, more so in a risk reversal where you have multiple strikes.

Ok sure.

I guess my core (probably naive) question still stands though. Realized volatility has to be 1 number between the time you open your trade and expiration: say 15%, 25%, 50%, etc. Doesn't this mean the skew at expiration must be 0? There is no such thing as "realized put vol" or "realized call vol" right?

If you are buying volatility from the OTM call at 10% and selling volatility from the OTM put at 20% doesn't that mean regardless of what realized vol is you will make that 10 vol spread, offset by potential losses from adjusting your delta hedge?