AJ Bairds' optimum option position

[MrMiyagi]

Just reading through Option Market Making again and came across a chapter that I missed completely the first time around.. After discussing the pros and cons of various strategies he arrives at the conclusion that the best holding a trader can have is a +theta +gamma position, achieved by going long flies in the front month and long wrangles in the back month. Cottle's Slingshot hedge method attempts something similar (in the front month only)..

Something I didn't fully understand: does Baird mean that market makers should try to manage their books to be as close to this structure as possible? Or is he implying that its a viable outright trade? I think I can just about understand the limitations of a position like this, such as the big profit holes either side of the front month wings, growing cost of adjustments/hedging in choppy markets etc etc; Its seems like a brute of thing for the regular retail trader...

I'm interested in how readers thought about this and the concept generally... Does anyone here trade in a similar way? How do you deal with entries / exits, legging in and out? What about whipsaw/choppy markets, how do you hedge, and is it worth all the trouble?

 

[slik]

As a market maker (well unitil I got canned recently!), having the +theta +gamma position is ideal: it means you get paid and am long gamma! The only way you get it though is by trading the vol surface- selling high vol options to buy low vol ones and traditionally (with a smile on the vol surface) that means selling the wings to buy the middle. To get +theta +gamma, you would have to sell more wings to the longs you have in the middle (think about the gamma/vega/theta distribution across the strikes) and selling more wings gives you a horrible upside and downside (your graphs would look pretty bad).

You can cover this risk by buying backmonth options but then backmonth options have little gamma and then you open yourself upto long backmonth vega which is dangerous in itself. And you are right the closer you get to expiration and you are sat in the middle of this iron fly, the more you will sh*t bricks in decay, you are essentially long a straddle that may decay to zero whilst short wings that will rip your face off in a violent move (given that these markets like violant moves right now, I would not reccomend being short wings in any markets - you wanna just be long , long and long options).

 

[MrMiyagi]

Cheers Slik, sorry to hear about the canning. I think Baird's view was that its preferable to be long the wings in the front month so that you can have time on your side, with the potential to participate in large moves one way or the other, however I see you're point on why its easier said than done. From you're post and elsewhere its getting clearer to me that Bairds advice is geared to market makers on how best to manage their book.. Although I can see the benefits for retail swing traders who are up for legging into a position like this over time aiming to complete it for a net credit... Just thinkin' out loud