Suggestion to the CBOE

[heech]

Quote from nitro:

You can hedge it with the little ATM strangle. What do MMs do when they sell ATM straddles or strangles that are even harder to hedge and manage than a pure vola play? Every problem this contract could have, the ATM straddle/strangle has 5x over already because they have delta, gamma as well as vola exposure. My contract is easier to hedge not harder.

MMs don't hedge "ATM straddles/strangles". They hedge their entire option book's delta. This is the real implication of Black-Scholes, isn't it? Options are priced such that if you delta hedge with the underlying, and statistical volatility proves to be in line with IV, then you don't lose/gain anything.

I don't understand how a MM hedges a position in your instrument with a little ATM strangle. If it was really that easy, then you nitro would just buy the little ATM strangle instead of asking the CBOE for this instrument. You don't do that, because the underlying moves. Same problem for the MM. What am I missing?

 

[nitro]

Quote from heech:
MMs don't hedge "ATM straddles/strangles". They hedge their entire option book's delta. This is the real implication of Black-Scholes, isn't it? Options are priced such that if you delta hedge with the underlying, and statistical volatility proves to be in line with IV, then you don't lose/gain anything.

Fine, so if the MM sell or buy one of these continuous ATM forward straddle (CATMS), it would be added to the MMs books vola risk, and he would hedge the book risk with this more or less vola in his book that the CATMS added or subtracted to his book. No different if _any_ option(s) is added or subtracted from his book as far as vola is concerned.

I don't understand how a MM hedges a position in your instrument with a little ATM strangle. If it was really that easy, then you nitro would just buy the little ATM strangle instead of asking the CBOE for this instrument. You don't do that, because the underlying moves. Same problem for the MM. What am I missing?

I do buy or sell the little ATM strangle amongst many other spreads. The problem is that I don't want the exposure to the underlying, hence my desire for a pure vola product. Similar instruments (in spirit) already exist for banks and they are extremely useful. I am just trying to bring these to the masses, in a simplified way so that it doesn't cost a fortune to put on and take off if you try to simulate the CATMS with vanillas.

Seriously, I realize you don't understand. From now on, any time you think you have a refutation, instead of thinking outloud here, think through your question and try to answer the same question when you add or subtract a straddle/strangle to a MMs book. You then have your answer for this product with the exception that it is much easier because he does not in addition have to hedge gamma or delta risk. His __hedge__ has delta or gamma risk where my product doesn't, but so would it have if I bought or sold a straddle from/to him.

Hedging doesn't mean you can go on vacation and forget about your positions. It means right now I don't have exposure to this or that greek if the underlying market moves a little bit. Since MMs do this for a living, and retail traders want to be able to go on vacation and forget about a position, this product would be extremely desirable for the retail trader. It would do exactly what MMs and __option__ exchanges want, bring them more volume.

 

[JohnGreen]

Nitro, I really like your idea. Anything which allows a retail trader to simplify a process or customize his risk exposure is a good thing. In this case, if I were vega negative overall, I could simply choose to buy some calls to neutralize my exposure should I desire to do so.

It strikes me (bad pun, I know) that this is a far superior replacement product for the VIX, which many people think is a good hedge without realizing that the VIX does not really do exactly what they think it does.

To make this proposal more specific, I think the product should be index connected which would avoid the company specific blips related to earnings events. They could start with the SPX, using the closest put and call strikes in the nearest expiry month to calculate the volatility [suggested symbol SPXV] and expand it to the NDX, using the same methodology [suggested symbol NDXV] and the Russel 2000 [suggested symbol RUTV] when the demand arrives.

I would suggest that the product would be best to have the strikes set for one or two percentage point intervals. Right now the IV is about 21%, so they could start with a range between 15 and 30 having puts and calls. It would also be best if the product was European style, with the exact same expiry as the SPX, and obviously it would need to be cash settled.

Market makers in the new product could buy and sell ATM straddles in the underlying to reduce or increase their option positions depending on their position in the new product. This could be a bit tricky at times for them, but if the pits were connected, it shouldn't be much of a problem given the large volume of trading in SPX.

 

[heech]

Quote from nitro:

Fine, so if the MM sell or buy one of these continuous ATM forward straddle (CATMS), it would be added to the MMs books vola risk, and he would hedge the book risk with this more or less vola in his book that the CATMS added or subtracted to his book. No different if _any_ option(s) is added or subtracted from his book as far as vola is concerned.

I don't know if you're clear how variance swaps function. Just by way of comparison: I'm perfectly willing to step into the VIX futures market and act as a market maker. Why? I can calculate (with minimal risk) how much it will cost me to get rid of my exposure using SPY options. The options hedge for the variance swap *is* static, meaning you buy it and forget it. (There is still some hedging with the underlying required, but minimal.)

Okay, let's not wave hands here, let's talk specifics.

Let's see I'm establishing a new market-making firm, and I'm interested in making a market in your CATMS. I have no other positions on my book, this is a brand new business. I'm here to offer liquidity and make money on the premiums doing so; I have no view, one way or the other, on future volatility.

I sit on the offer slightly about current ATM IV. Some speculator (maybe you) comes in and hits me for 1000 contracts. I'm now short 1000 units of your CATMS.

How, specifically, do I hedge this short vol position? Again, I don't actually WANT to be short. The other guy above me said I just buy the ATM straddle/strangle. Okay, and what happens when the underlying moves? Buy another set of ATM straddles/strangles? That means it's certainly not free. How do I quantitatively calculate my potential hedging costs, here?

The only way I make your instrument work, is the same way I'd make a market in any instrument without a liquid, arb-able replacement instrument: I can only live off of huge ask/bid spreads, and I will move the market substantially based on where my net position is. Just like a Vegas bookmaker.

And, I still don't see how you keep prices in line. You talked about cash settlement. Okay, let's say settlement date is 3 days after earnings. That means your CATMS will trade at a steep discount to current market values for IV, correct? How do you "arb" and keep CATMS prices in line?

Obviously I see the appeal of something like this. Option market makers would love to be buyers of this instrument as well, so they can get rid of the structural vega most of them are carrying on their books. But my understanding is that market constraints are a big determinant of what instruments are eventually created.

I was pretty excited about the RUH (realized volatility) options that the CBOE was to launch back in 2008, for example. I would've been a big user, and I think others would have been, too. A few months later, they pulled it, and it's back to the drawing board. I've been told it's because market-makers found it too hard to implement the hedge.

 

[tomk96]

everybody uses vol. not vola. i can't even read through all the posts because it is driving me batsh!t crazy.

you want a vix style future on every equity, right? to give you exposure to vol, but not have to deal with delta nor gamma? so if you want to make a clear vega bet, you could go to that?

a couple thoughts...

there are way to many equity product listed to also list your product and find market-makers for them.

without a build in volume, the markets would probably be so wide, you wouldn't want to trade it anyway.

if it's priced off the front two at the forward strdls, how does it ever expire? do you want to essentially then create an ETF? if that's the case, the cboe won't be any help to you unless you make it an exclusive product to the cbsx.

trying to get a better understanding of what you are asking to figure out if it is totally genius or absurd.

 

[nitro]

Quote from heech:

...

I sit on the offer slightly about current ATM IV. Some speculator (maybe you) comes in and hits me for 1000 contracts. I'm now short 1000 units of your CATMS.

How, specifically, do I hedge this short vol position? Again, I don't actually WANT to be short. The other guy above me said I just buy the ATM straddle/strangle. Okay, and what happens when the underlying moves? Buy another set of ATM straddles/strangles? That means it's certainly not free. How do I quantitatively calculate my potential hedging costs, here?
...

What you want is a hedge that allows you to turn a CATMFS into a "box" so that you have no risk whatsoever. Since only one of these exist per month in my original proposal, there is no direct way to do that particular hedge in the same month with an _exact_ contract like it. If this was deemed critical, then we can ammend the original idea as follows.

Your fear appears to be, what if this product takes off, and now people want _only_ CATMFS and don't want any other option contract. What would happen in that case is that MMs could then become exposed to directional vola plays with no way to offload that risk. Maybe. If this is the case, then in addition to quoting the CATMFS, add sticky delta contracts at certain delta intervals from the CATMFS that MMs must also quote. So instead of just the ATMF strike straddle, MMs would have to also quote sticky delta strangles (a straddle is just a degenerate strangle just like a circle is a degenerate ellipse) in say 5 delta increments from the CATMFS all the way say to the 25D strangles. This would allow you to hedge any particular combination of these pure vola contracts with each other in a precise mathematical way. So now you could have "Iron Condors" and "Butterflies" of continuous sticky delta vola contracts.

I realize this would add a few more instruments (depends on how many delta strangles you want - every 5 deltas from 50 would add 45/-45, 40/-40, 35/-35, 30/-30, 25/-25 or five more continuous OTM strangles (COTMS) to the CATMFS), but it is well worth it imo since you get pure exposure to vola level at every part of the curve without having to worry about underlying exposure.

 

[tomk96]

why don't you just roll your position? that's what everybody else has to do.

 

[tomk96]

if you want exposure to only the front month or 2nd month vol. only, you are asking for a future on the stock's vol. or a vix style future. there is no need to have somebody quoting you a straddle and 15 different strangles to give you this exposure.

how does your contract expire? it needs to expire. i'll gladly sell you as many floating strangles as you want since they will apparently expire worthless anyway.

 

[nitro]

Quote from tomk96:

why don't you just roll your position? that's what everybody else has to do.

What does what everyone else do have to do with the idea for a potentially new useful product? Either it is useful or it isn't. What anyone else does or doesn't do is irrelevant.

 

[nitro]

Quote from tomk96:

if you want exposure to only the front month or 2nd month vol. only, you are asking for a future on the stock's vol. or a vix style future. there is no need to have somebody quoting you a straddle and 15 different strangles to give you this exposure.

how does your contract expire? it needs to expire. i'll gladly sell you as many floating strangles as you want since they will apparently expire worthless anyway.

What I want is exposure only to the extrinsic portion of the price of an option, and I want it to be as close to ATM as possible. The VIX style product you are suggesting may do the trick, I haven't thought it through. The problem is the complexity of the product intermingles the two vola strips with each other in a complicated way (if done the way the standard VIX does.)

Read the thread. The contract expires when the other options do. The contract is worth zero at expiration. It is by definition "pinned."

Yeah, the sticky strangle may not work as a hedge, since no possibility of it ever being in the money. But then neither is the CATMS ever in the money either by definition. I guess there is no hedge possible with a like contract.