what is the best way to trade skew while hedging delta, gamma, vega, and theta?

njrookie · Oct 10, 2011

How to trade the direction of vertical skew if you can predict the direction of skew movement?

Let us use SPY for example. Say today imp vol at 105 OTM strike is 50 and at 115 ATM is 30. If you think tomorrow skew is coming down from 50-30=20 to 18, what is the best way to trade it without taking on delta, vega, gamma and time decay risks?

I am thinking of a ratio put spread with ratio set at the ratio of inverse local vega (calculated at BS imp vol) b/w the two puts. Then delta hedge the spread with spy. This is not vega, gamma and theta neutral however.

Any suggestions or comments?

njrookie

newwurldmn · Oct 10, 2011

Quote from njrookie:

How to trade the direction of vertical skew if you can predict the direction of skew movement?

Let us use SPY for example. Say today imp vol at 105 OTM strike is 50 and at 115 ATM is 30. If you think tomorrow skew is coming down from 50-30=20 to 18, what is the best way to trade it without taking on delta, vega, gamma and time decay risks?

I am thinking of a ratio put spread with ratio set at the ratio of inverse local vega (calculated at BS imp vol) b/w the two puts. Then delta hedge the spread with spy. This is not vega, gamma and theta neutral however.

Any suggestions or comments?

njrookie

how much money do you expect to make on a trade like this relative to your account?

My experience has been that it's not worth the effort (especially when you start getting into the vol of vol and dgamma/dspot and ddelta/dvol risks.

njrookie · Oct 11, 2011

I am exploring new opportunities. I have a decent size account (>>100K) and am making money with other strategies.

Even 10 or 20 bps a day is good. I just feel the edge in predicting the direction of skew is there. I do not think the risk is not manageable especially at daily rebalancing/hedging.

njrookie

Martinghoul · Oct 11, 2011

I think sle once posted smth about this... I am not sure it makes sense to try doing this with everything minimized, as it will be too costly. I generally like to do 1x2s, but there are no hard and fast rules.

ASE1245 · Oct 11, 2011

Quote from njrookie:

How to trade the direction of vertical skew if you can predict the direction of skew movement?

Let us use SPY for example. Say today imp vol at 105 OTM strike is 50 and at 115 ATM is 30. If you think tomorrow skew is coming down from 50-30=20 to 18, what is the best way to trade it without taking on delta, vega, gamma and time decay risks?

I am thinking of a ratio put spread with ratio set at the ratio of inverse local vega (calculated at BS imp vol) b/w the two puts. Then delta hedge the spread with spy. This is not vega, gamma and theta neutral however.

Any suggestions or comments?

njrookie

In the end, if you believe a skew will change, or the vol curve will lift or drop, you have to take on risk some where. The more you try to avoid risk, the less profitable the trade will be. I would suggest stay delta neutral but don't over trade. Choose where you allocate your risk. Ratio spreads are a good way to profit from these moves. Trading volatility changes in strikes that get out of line from a large order, is a great way to profit in the option markets. I made a living doing that for many years. Entry points become easy, exit points are the hard part.

Bob

quatron · Oct 11, 2011

Quote from njrookie:

I am thinking of a ratio put spread with ratio set at the ratio of inverse local vega (calculated at BS imp vol) b/w the two puts. Then delta hedge the spread with spy. This is not vega, gamma and theta neutral however.

You can't be vega neural if you want to trade skew. You need to be short vega to profit from falling vols. In this case theta is not a problem. However with ratio spread you are taking slope risk. It's when the skew is turning, imagine the vol is falling at your long puts strike but rising at the short puts strike. It's hurts more close to expiration.
You can go short atm straddle. Then hedge delta as needed. You will have only gamma risk. Or go long butterfly if you want to have less gamma risk.

MTE · Oct 11, 2011

Quote from quatron:

You can't be vega neural if you want to trade skew. You need to be short vega to profit from falling vols. In this case theta is not a problem. However with ratio spread you are taking slope risk. It's when the skew is turning, imagine the vol is falling at your long puts strike but rising at the short puts strike. It's hurts more close to expiration.
You can go short atm straddle. Then hedge delta as needed. You will have only gamma risk. Or go long butterfly if you want to have less gamma risk.

Actually, you are wrong. The OP wants to profit from the change in the spread of the implied vols at the two strikes (i.e. skew) and he/she doesn't care about the fall in the overall level of implied volatility.

Slope risk is exactly what the OP wants!

newwurldmn · Oct 11, 2011

Quote from njrookie:

I am exploring new opportunities. I have a decent size account (>>100K) and am making money with other strategies.

Even 10 or 20 bps a day is good. I just feel the edge in predicting the direction of skew is there. I do not think the risk is not manageable especially at daily rebalancing/hedging.

njrookie

How much vega a leg will you need to trade to achieve this? How much margin will it take? Reg t will be impossible and skew is generally gap risk expensive for pm accounts. You are better off trading one leg and doing less of it.

quatron · Oct 11, 2011

Quote from MTE:

Actually, you are wrong. The OP wants to profit from the change in the spread of the implied vols at the two strikes (i.e. skew) and he/she doesn't care about the fall in the overall level of implied volatility.

Slope risk is exactly what the OP wants!

Yeah, my bad, wasn't reading careful enough.

sle · Oct 11, 2011

Quote from njrookie:
How to trade the direction of vertical skew if you can predict the direction of skew movement?

What exactly do you mean by "direction of skew movement"?. When you are trading the skew, there are 3 principal risks (sources of P&L):

(a) the actual change in the slope of the skew in the implied space. e.g. if you are trading 95% strike against 105% strike and your underlying stays in place, all of your instantaneous P&L would be due to the changes in the implied vol at each strike times the vega per leg

(b) realisation of volatility across the strike space. that is, if the underlying drifts to one of the strikes, what would be the volatility realized along the way and how it relates to the original diference in vols that you locked in

(c) the implied volatility of across the realized strike space. that is, if the underlying goes to the viscinity of one of the two strikes, what would be the implied volatility that you have to buy back or sell

In general, what you are going to trade is either going to be some sort of risk reversal/collar or a 1 by N put or call spread in a delta-neutral manner. It is, however, very hard to separate the 3 risks above from each other using vanilla structures, assuming that your underlying actually moves. Does that make sense?