Options relative value

[rvtrader10]

Is it a good idea trading an index option versus another index option, assuming that correlation between the two indices is high? Basically playing one equity index to be more volatile than the other?
Or given the features of options there are too many risks involved?

Thank you

 

[Rhody Trader]

These are examples of spread trades and they are definitely done. Whether it's a good idea for you is a whole other discussion.

 

[rvtrader10]

Can you enlighten me on where this kind of trade is properly explained?

Thank you.

 

[seancranky]

statistics, I would say

 

[seancranky]

By the way, I don't really believe in that, simply I don't have a deep pocket and one big failure will just destroy me. Especially when I am not hedged.

 

[rvtrader10]

What I am saying is: does it makes sense trying to extract alpha from i.e. a call on FTSE vs a call on DAX, same expiry date and out of the money by the same %, or ATM. Or the time decay can definitely play against me?
Furthermore, it looks pretty tricky to analyse historical options prices...how would you do that?

 

[seancranky]

Dear rvtrader10,

What you said makes sense totally. Have heard of the term "volatility arbitrage"? It's this sort of thing.
For example, suppose one FTSE straddle is 10 euro, one DAX straddle is 5 euro (I just made it up), However you find that the volatility of DAX is more than half of FTSE, which you may calculate from historical data (like daily movement). You can short 1 FTSE straddle, long 2 DAX straddles, where initially you don't invest any money. What you expect is when FTSE moves, saying, 4 points, DAX moves more than 2 points, then your portfolio will be positive.

This is just a strategy, I know some people use it, it's up to you.

regards,
sean

 

[seancranky]

As for different expiry dates, you can wikipedia "calender spread". You seem to be fond of options, they are interesting aren't they?

 

[rvtrader10]

Thank you Sean.
In fact, I am exploring different areas trying to understand where and how it's still possible to extract some alpha.
In the example above, I was rather looking at some statistical RV on option prices rather than pure volatility arbitrage. To keep it straight: I would check correlation between two indices; if it's high I can assume that volatility will be very vey similar (I can easily compare realized volatility too). Given this, I am expecting to pay the same money to, let's say, buy protection on both indices, 2% out of the money let's say.
As soon as the spread of implied volatilies move away from the mean I will sell the expensive one and buy the cheap one, waiting for a reversal.
The idea is definitely fascinating but: how can I manage the time decay effect? If the pair doesnt revert quickly I will easily end up with a pair of options completely worthless. Am I right?

 

[seancranky]

rvtrader10,

I know, time, the enemy of gamma.

My suggestion is, you can short strangle (if that's what you meant by protection) on one side and long strangle on another side, then you are neutral to time, and wait for a reversal.

Normally shorting options means risk, but that's the only choice if you want no time decay effect.

In my very personal opinion, probably the bid/ask spreads of options will make you suffer when you change position, god I hate them.

 

[Martinghoul]

Why don't you look at these books by filthy? They're pretty good:
http://www.amazon.co.uk/Option-Trad...=sr_1_1?s=books&ie=UTF8&qid=1284982508&sr=1-1
http://www.amazon.co.uk/Volatility-...=sr_1_2?s=books&ie=UTF8&qid=1284982508&sr=1-2