Selling OTM just before expiration
- Thread starter cabkraft
- Start date
Would you be able to disclose the name of this fund?
With all due respect, I don't get the logic behind Atticus' system/suggestion to the HF. Dispersion trading with ATM short straddles on the day of expiration while having a plan for assignment thru pin risk does not compute for me. Can someone be so kind as to explain how this makes sense, especially since all time premium is virtually gone.
Walt
Walt
Since he's not answering I'll take a guess, tell me if this sounds right ...
The options are overpriced b/c shorts want to get out and there is no liquidity. So you are getting more time premium than you should according to a reasonable model. If this is true you would make money on average from selling these straddles and then dumping whatever stocks you pick up on monday.
The dispersion part is really just a hedge against the hopefully rare large market-wide move against you. You buy an index straddle, which is more reasonably priced and liquid than what you sold. You get paid for providing liquidity to desparate buyers in an illiquid market and hedging in a liquid one. You still have basis risk, because there is a mismatch between your basket and the index, and something that affects one stock alot but does not move the index will hurt. But hopefully these losses are small relative to what you make on the rest.
My naive plan for assignment would be to unload as fast as you can assuming your hedge expires the same time as the options, if the meat of the strategy makes enough maybe this is all you need to do. But maybe they do something else if they have to unwind slowly or preserve small gains - hedge with index futures after the long straddle expires maybe?
BTW, perfect pinning would mean no assignment at all and would be good, so I don't know what you mean by assignment through pin risk exactly.
Good try Blackdiamond...
However, short straddles on the day of expiration ATM don't have enough Premium (even if they're overpriced) to enable the HF to earn more than 100% per year. Atticus stated that the objective is to incur an assignment, so you may very well be in the "ball park". I would be highly concerned about a gap against me over the weekend with an assignment at expiration.
It still doesn't add-up to me...
Walt
However, short straddles on the day of expiration ATM don't have enough Premium (even if they're overpriced) to enable the HF to earn more than 100% per year. Atticus stated that the objective is to incur an assignment, so you may very well be in the "ball park". I would be highly concerned about a gap against me over the weekend with an assignment at expiration.
It still doesn't add-up to me...
Walt
That doesnt sound right. After expiration on saturday, you are saying the hf is basically unhedged with a large amount of open positions until monday morning? A lot could happen on sunday/weekend as we saw in the last 2 months. Just doesnt seem to make sense a hf would do that...
i must be missing something or didnt understand fully..hmm
What product are they trading? Perhaps these guys found an edge, but I wouldn't think the edge would be available on every underlying.
Good points. Maybe they just make up the returns and use new investor money to pay redemptions 
Seriously I don't know what a reasonable ballpark price for an expiration day straddle is or how much an aggressive fund could leverage it up. If you guys do please share. 100% per year does sound huge, especially for being out of the market all but 2 days of the month.
I don't thing the risk is neccessarily unmanageble though. You pretty much know what your assignments are before the index futures close on Friday, so you can net out the longs and shorts and hedge the difference.
Then it is a question of whether you are getting paid enough to take the basis risk. And making sure you haven't leveraged to the point you blow up the one month all your assignments move in the opposite direction of the index.
Or maybe they take the long straddle hedge in the next expiration month and partially unwind it when they find out what their assignments are, and keep the rest on until they unload the stock/cover shorts? Then spend the weekend flat delta, long gamma and vol, but still take basis risk. I'm too tired to think hard about that one tonight.
Seriously I don't know what a reasonable ballpark price for an expiration day straddle is or how much an aggressive fund could leverage it up. If you guys do please share. 100% per year does sound huge, especially for being out of the market all but 2 days of the month.
I don't thing the risk is neccessarily unmanageble though. You pretty much know what your assignments are before the index futures close on Friday, so you can net out the longs and shorts and hedge the difference.
Then it is a question of whether you are getting paid enough to take the basis risk. And making sure you haven't leveraged to the point you blow up the one month all your assignments move in the opposite direction of the index.
Or maybe they take the long straddle hedge in the next expiration month and partially unwind it when they find out what their assignments are, and keep the rest on until they unload the stock/cover shorts? Then spend the weekend flat delta, long gamma and vol, but still take basis risk. I'm too tired to think hard about that one tonight.
You're in the ballpark on ROI. The fund is small [~30MM] but produced compounded returns at 80-100% with a 10% peak to trough DD. The expiration methodology is only a 30% allocation; the remainder is allocated to rollover, skew/smile and stat-arb strategies. The expiration strategy is responsible for ~40% of the aggregate ROI.
There is no objective to incur an assignment -- it's a cost of doing business. The objective is a close at the neutral strike and an efficient offset on the Monday following expiration.