This is the position Tony Saliba used to make his money in the eighties. Back then, however, vol surfaces were less efficiently priced. I would think that if you did a basket of these and hedged out long vega risk by selling index vol you will start to approach a dispersion position. Problem is that 1. you will need to sell a ton of index vol to compensate you for the theta you are paying and this will cause pain when vol goes up. 2. you will need to scale your book up a lot to make enough return to make it interesting for you. I bet the upward sloping termstructure also makes this annoying from a carry perspective.
Unless you have an exceptional knack for timely selection of UL's that move up/down dramatically and/or experience a decent amt of IV expansion, you're going to get into trouble with 2:1 ratios. The time decay will kill you. Add to that a hedge that has the potential to periodically add to that loss and you're going to need an UL that really cooperates (think '08/09's volatility vs last year's stagnation).
I think I'll keep it simple and stick to setups that are easy to understand and hedge. The more complex you get, the more pain. Tarzan can do Jane all he wants. I'm not dealing with a messy buttcrack...
Great points, thanks guys. I use the calendar/straddle combination much more frequently than the double diagonal ratio for similar reasons. The VXN idea is really more like an alternative adjustment to stay in the trades and lock in profit after IV did what I expected. I am less interested in creating a hedge upon entry when IV is at extreme lows. Usually the vega/theta ratio is around 10:1, and although theta is where a loss will most likely come from if IV doesn't move, I am still more interested in vega. Time is the one thing I CAN control, and with the TLJ, a small move in IV can easily absorb the time decay. That being said, this is just another tool in the bag for the right situation. The original post is really less about the TLJ being a viable strategy, and more about coming up with an IV correlation tool that can be used to create a more precise hedge for any portfolio or combination of strategies.
Sticking to easy to understand setups is good. Finding similar set ups with higher R/R ratios is better
It should be fun just paper-trading it.. I think I'll try that and see how I cope with it. Anybody with suggestions on any particular underlying at the moment? Specific strikes and lot sizes would be appreciated.
I usually just start out by scanning the "penny pilot list" using a skew finder. Searching through low IV breakout stocks can also be useful. On most platforms you can at least start by finding stocks with a high SV/IV ratio, and then just try to pay attention to dividend dates. It is similar to a calendar before earnings, but it can be on a stock that moves. If you start with all legs using the ATM strike, you will notice that it will most likely need another put to keep the balance. For example: Long 4 May Calls Short 2 Apr Calls Short 2 Apr Puts Long 5 May Puts Unless you change the ratio, vega will decrease as you move the long strikes away from the money. Entering this all at once requires the right situation so I usually just end up adjusting into it from a calendar or a few layered calendars using a long straddle in the back month. The straddle costs some theta but it reduces directional risk and allows for a bit more vega sensitive "IV ride" the rest of the way up to an earnings announcement.
So you enter into a Calendar first, then see if it goes your way for a few days, then enter into the rest of the legs?