Hi, I am new to options (FX options). I would like to know more about vega neutral trading strategies. I understand that vega neutral means you buy an option and you sell another to make the overall vega = 0. Eg a calender spread: buy a long end EUR call USD put and sell the front end EUR call USD put. 1) How then do make money from your trades since vol will have no effect on your portfolio?
say you're bullish vol. you buy a call a sell delta shares. now say your prediction realizes. your options is now worth more while your short value is unchanged. it is not gamma trading in that you set up this trade because you thought that implied vol was cheap in absolute terms vs implied vol was cheap relative to realized in the case of gamma trading. you shall prefer long-dated options.
You're using a model to calculate vega. That model is wrong. Don't think for a second that simply putting on position with an initial vega of 0 means that vol won't affect your P&L. Yes, vega hedging is useful, but you have to be careful with it. For instance, you cannot add raw vegas of different expiries, you have to adjust by root-time, which itself is a theoretical adjustment. The term structure will oscillate via supply/demand and could deviate from fair/theoretical. Moreover, you have to account for higher order derivatives. Vega itself is convex. As the underlying moves, the position vega will move away from 0 in either direction. Always ask yourself the question, what does my vega look like in either tail of the distribution? To directly answer your question, a basic volatility "arbitrage" trade would be a risk-reversal. OTM puts are expensive relative to OTM calls (assuming an index here). Sell the OTM puts, buy the OTM calls, use ATM options to zero your vega, and the underlying to zero your delta from there. At the end of each day, rebalance vega and delta, and at expiration you might just have a profit. Unfortunately, as I said before your model is wrong. You don't know the actual price process. Is it a Wiener process? Jump diffusion? Moreover, you're hedging in discrete intervals which introduces path dependency. Black-Scholes is right ON AVERAGE. But you quickly learn in option trading that relying on the first moment will get you your head handed to you.
Just for "fun" (me at least), here's a little toy I've been playing around with. It basically amounts to "back-of-the-envelope" analysis of empirical vol/skew. I say back-of-the-envelope because yes, it uses simple black-scholes and assumes discrete delta hedging at market close each day. The template is poorly organized as this is something I threw together while playing out an idea in my mind, so for that I apologize. Basically, this spreadsheet takes historical price data for a stock and calculates the "fair" realized IV skew for an arbitrary period. All you do is goal-seek the IV that results in a 0.00 value for the delta hedged option. In this case, I chose AMZN as the stock and looked at a few 25 day periods over the last few months. What's interesting to me is if you look at the second tab, you'll see a fairly normal skew case juxtaposed with a few jump cases. Anyway, this is just an example of some simple analysis. By no means is this correct (I'm sure there are some glaring errors) or close to the only way of going about this stuff, but I still see value in it as you can glean some generalized results about the underlying. Hope this helps. Credit for the vba code goes to Paul Wilmott.
Vega is the most unreliable of the Greeks- be aware that options neutrality is a passing phase and things soon get out of wack-hopefully to the trader's advantage- I think Jared Woodard has excellent research on vega
unreliable as in ..... delta and gamma are fairly good metrics,but vega can be a wild ride-vol is subject to many deviant forces,from liquidity to the spread to a simple error at trade entry. (what's your vega at entry-you only know once you have done the trade) While VIX is meant to be mean reverting,it can take a very long time to revert.
Vega is actually pretty accurate. You sell 30 vol ATM. You carry 26 vol throughout. Your pnl is very close to 4 Vegas (from inception). Re: what's your vega at entry. You don't know your delta either until you make the trade.