OK. Because the SPX is free-float market cap weighted it has a (relatively) leveraged exposure to the Tech (high beta) sector of the economy. Now, the DJIA is an all-sector, price-weighted index, so it attempts to balance the risk across all sectors of the market. Therefore, if you are long/short SPX against a DJIA hedge, in a typically traded ratio, then you will have exposure to the NDX. There's other ways to trade the ratio (like a volatility hedge) and the spread is very actively traded by algorithms/robots co-located/quant hedge funds etc. You should think of this as a market maker spread, and as a synthetic index, and a futures spread. Before the micro's were introduced, this was one of the only ways to get (very small) 24/5 liquid exposure to the market for swing trading.
I did some quick thinking: I suppose a quick and dirty solution could be to delta hedge such that you keep your total delta around 0. With ATM options on the long and short legs, you are +50 on the long leg, and -50 on the other. If prices, and accordingly deltas, move, to e.g. +60, -40, you could delta hedge by selling 10 in the underlying on the long, and +10 on the short leg. If the mean moves away too much, I suspect this won't work anymore either because of the other Greeks. Also came across this paper, they don't do exactly what you want as they speculate on IV, not on the underlying, but still. They report no substantial profits though: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3914713
Banks trade against clients left and right. All Dodd frank did was hide the prop trading; it explicitly allowed banks to take principle risk to facilitate client orders. They hedge the correlation risk with other correlation products, not explicitly with vanilla products. So because the hedge is imprecise, you can imagine what the spread is.
@MrAgi1 before you get down into the rabbit hole of structured products, think about the original trade for a minute: Spreads = low tail risk Can you really subscribe to that idea? Would you come to the conclusion that you did not map out every scenario and just looked at tail risk from a simplistic point of view aka. tail risk = stock market crash. If you look at real world examples, spreads are the mother of tail risk assets. Because spreads are basically turkey markets...they keep their historical relationships until there is a major paradigm shift and then everyone is getting their ass handed to them. NatGas Rates/Rate curves Indices (Eurostoxx vs DAX, S&P vs Nasdaq) FX carry trades NDFs vs cash settled products commodity spreads (Brent vs. WTI, ags.) The list goes on and on. Hedging tail risk in the outrights just opens you up to tail risk in synthetics...and more often than not these are much more severe. So before you go all out on fancy nonlinear structures, think about the basic asumtion of your original trade idea.
Interesting. I understand how it possible for divergence to occur when we use different indexes or commodities for a spread trade. However, for a spread within the same product(calendars), I would expect both contracts to move the same way. For calendar spreads: long near month futures contract of CL and short far month contract of CL. How is it possible that during a market crash, one month is moving up and other is moving down?
You have to trade like 3x the spread to get the same pnl volatility as the outright. That adds leverage making the spreads trickier.
One month moves up much faster than another month: in the case of CL, changes in the arbitrage condition like in the negative oil debacle where only the front went negative.
Do you remember CL May 2020 settling at -37.63$? What happened to the guys who loaded up on "low risk" 1m calendars to arb a couple of cents of curve dislocation? If you were long May/short JUN for 10 contracts you would have lost almost 400k... If you trucked along for years with your spread book and made consistent profits, that tail event 100% wiped you out of the game if you had that position on
Wow. Did not know calendars could also behave wildly . So neither pairs or calendars are useful to reduce or eliminate tail risk. I guess it’s impossible to avoid tail risk events or maybe hope for luck. Unfortunately.