I think it's all a variation on a theme. Often with different objectives and intent but sharing similar characteristics nonetheless. I was going to summarize the approaches more formally but will do a quick summary here for everyone's benefit for folks that are interested.
I will restrict discussion mostly to the treatment of credit spreads for simplicity of terminology but the same principles can be extracted for application to ICs
Concept
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I personally think about it in terms of a play on sigmas. Banking on the 1 sigma move. Assuming it will almost definitely move and capitalizing on that move. At the same time betting that it won't move enough to make your spread a loser.
To hedge the short positions on your spread or speculate on direction opposite to your short positions.
Whether you think about it as a hedge or as speculation is probably moot though your perspective could very well influence position sizes and timing etc.
Same Instrument vs. Different Instrument
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This strategy can be applied on the same instrument e.g. SPX and SPX or can be applied on similar instruments e.g. SPX for credit spread and XSP/SPY for the hedge as per Coach.
Single vs. Debit Spread
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Buying long singles vs. long verticals. Obviously the long vertical "costs" less at the expense of capping profit potential and also capping off the gamma hedging capabilities for your credit spread.
Legging in to the long vertical or not
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One may be inclined to have conviction in the direction that favors the hedge and then leg into the long vertical as movement allows. This is sometimes referred to here and elsewhere as "building up free hedges" as per Coach on SPY hedges and Andy Smith amongst others.
Considering legging into the PREGO fly is also an option to reduce the cost basis. The PREGO fly is simply a wider long vertical opposite a narrower short vertical. Need to pay attention to the ratio's though.
ATM vs OTM
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Putting on the hedge ATM, in the case of an IC this would mean putting on a straddle to hedge the IC as per Riskarb. OTM would mean a strangle for the IC example.
The ATM hedge obviously costs more than the OTM hedge which could quite easily decimate any credit from the credit spread and thus the ratio could end up being quite steep. However, one has to look at the gamma hedging capabilities of ATM vs OTM to make this decision.
Furthermore, if you go too far OTM with the hedge then there is every chance you make no money on the hedge and significantly reduce the credit received for no benefit.
Proactive vs Reactive
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One can choose to put the hedge on at the same time as the credit spread and thus accept the hedge as a cost of doing business or alternatively the hedge can be placed reactively as per the Slingshot or PREGO butterfly approach.
It's important to realize that some people would not see the hedge as a cost but as a way to make more money. So again, perspective plays a large part in the approach.
I've simplified the above for the sake of brevity but I believe I've covered the main factors there are for consideration when employing this strategy.
Food for thought. Prosperous trading.
MoMoney.
Quote from labib52:
I wrote about similar strategy (post 568) but I used a debit spread. This way you could reduce your cost and increase the No of your contracts .
