Call Option on the ES-NQ futures spread

[boba15]

Hi, folks.

Does somebody know how to construct a Call Option on an intermarket spread (say +1ES-2NQ)?

So that it would behave the same as if +1ES-2NQ were one symbol?

Any help is greatly appreciated.

 

[inertia_trader]

Does somebody know how to construct a Call Option on an intermarket spread (say +1ES-2NQ)?

So that it would behave the same as if +1ES-2NQ were one symbol?

Here are 2 ways to do it:

1. Long call(s) on ES + long put(s) on NQ.
In choosing the strikes, make sure that

delta(ES calls)/50 = -delta(NQ puts)/40​

2. If you find yourself favoring the in-the-money strikes in method 1,
it's worth checking the synthetic equivalents for tighter markets:

1 Long ES + 1 Long otm put on ES - 2 short NQ + 2 long otm calls on NQ

As in 1, make sure the option deltas are in proper proportion.
For each ES-2NQ spread, make sure you satisfy the equation:

(50 + delta(ES put))/50 = (40 - delta(NQ calls))/40​

I strongly suggest paper trading something like this a few times before
committing real money.

Good luck!

 

[boba15]

Here are 2 ways to do it:

1. Long call(s) on ES + long put(s) on NQ.

inertia_trader, while I appreciate your reply, I don't think it's correct: let's consider two 100% correlated instruments with a spread of say 5 points between them. That is, all the time the spread is constant: 5 pt, apparently, volatility of the spread is zero, so the call on this spread should also cost close to 0. Which is not the case when you buy call and put as you suggested (as volatility of each pair constituents can be high).

So there must be both buying and shorting options... If it's possible theoretically at all.

 

[inertia_trader]

inertia_trader, while I appreciate your reply, I don't think it's correct: let's consider two 100% correlated instruments with a spread of say 5 points between them. That is, all the time the spread is constant: 5 pt, apparently, volatility of the spread is zero, so the call on this spread should also cost close to 0. Which is not the case when you buy call and put as you suggested (as volatility of each pair constituents can be high).

So there must be both buying and shorting options... If it's possible theoretically at all.

A valid point, boba15. The more I think about it, what I described is really more akin to a call option on the spread, plus a strangle on the components. It has strangle characteristics since if both markets were to zoom to the Moon (or fall down the cliff), I would make a lot of money (even if the spread stayed constant) because gamma would come to dominate. Countering some of that gamma would require selling options, as you suggested.

Unfortunately, it's the best compromise I've been able to find. If you use method 1 and buy your options sufficiently in-the-money, use a far expiration month, and roll your options out to farther months when opportunity presents, I would hope that the time value loss per day shouldn't be that bad. (I am assuming this is for somewhat of a intermediate or long-term trade.)

 

[dr_sean]

Right, the position that inertia_trader mentions is not a call on the spread at all, it is an intra-market straddle.

Think about it in vol terms: you can't trade a product that trades the spread and not the two underlying product. Not unless you could get somebody to list it for you. Who wants to put a value on the implied vol of the spread? There you go.

If you go back to Natenburg and the description for the nature of an option, it is a instrument that does your dynamic hedging for you. So if you can't get the option, build a synthetic one just by hedging it.

So set up position X (say, long 10 /ES futures & short 20 /NQ futures), and then, if the spread value increases, add onto the position as you go, simulating long gammas, say to X+1 (e.g., long 12 /ES and short 24 /NQ). If the spread moves down, decrease the position. The whole more aggressively you hedge, the cheaper you're paying for the synthetic call but the less likely you are to make a profit.