Delta-gamma neutral, long vega trade

Discussion in 'Options' started by DarkProtoman, Mar 31, 2009.

  1. Would entering into a spread that's delta-gamma neutral, w/ a long vega be profitable, if you enter a few weeks before the release of the underlying's quarterly earnings, and then close out a day before the release?

    My theory is that, since IV is low a few weeks before a company's earnings release, and then starts rising until the ernings release, I should be able to profit soley off the rise in IV, if I remain delta-gamma neutral, so I won't get slammed if the underlying goes up/down.

    This a good strategy? Has anyone used it before?
  2. dmo


    Think for a moment how you would actually create such a position - gamma neutral but long vega.

    The only way I know to do that would be to buy back month premium (options) and sell front month premium. If you do it at a ratio that gets you gamma neutral, you are buying more back month options than you are selling front month options. That makes you very long vegas, and approximately theta neutral. Assume also that you are delta neutral.

    So assuming that the relationship between front-month IV and back-month IV stays the same, this seems like a good plan. HOWEVER - what if the relationship between IV in the front and back months does NOT stay the same? What if front month IV (which you are short) goes up significantly, while back month IV (which you are long) doesn't move much?

    That, it would seem to me, is the likely difficulty you face in making this strategy work.
  3. Ah...any other tips? What situation could cause such an IV discrepancy? Would it be simpler for me to simply be delta neutral, and dynamically hedge?
  4. dmo


    Forget dynamic hedging - it may work well in academic papers but in real life it comes out to closing the barn door after the horse is gone.

    If playing the IV of options on stocks around earnings reports appeals to you, nothing wrong with that. Sounds like a perfectly valid approach. What I would do is start studying the patterns of IV in the front and back months starting a few weeks before earnings, and especially right after they're announced. TOS' Think Back feature is wonderful for that.

    As you study stock after stock, certain patterns will emerge. You'll become familiar with what's normal and what's not. Don't expect it to be quick or easy.

    After a while, you'll recognize anomalies, and you can play them. For example, if for some reason a stock's options are at a low IV and DO NOT rise in anticipation of earnings - or better yet fall - you may want to buy straddles the day before earnings come out. This is a sign of complacency and for options, complacency is like dry tinder. Any surprise will likely cause the stock and the options to go crazy, and you will be a happy pappy.

    Or perhaps the IV of the front month will rise exorbitantly in anticipation of earnings, while the back month does nothing. In that case you may wish to short front month premium and buy back month premium.

    The main thing is (and I keep saying this here although nobody wants to believe me) - forget about a "one-size-fits-all" strategy for earnings (or anything else). If you're a retail trader, the only way to make money consistently is to know something cold, recognize when there's an anomaly, and play it. You have to tailor your strategy to that particular situation and that particular anomaly.
  5. Don’t take this the wrong way but you’re not the first to think about this sort of play. There is a very very fine line or window which can at times allow this to be a profitable strategy. The problem becomes one of theta vs. Vega. If you’re looking at the front month then the question is when do you buy vega? Too soon and the theta will take out your profit potential despite a rise in volatility, too late and you’re already paying a high price to own vol. It’s not as simple and buying vega then managing the delta and gamma issues so you can sell the vega out.

    If you use further out months that’s fine in terms of theta but then you run into the issue of much smaller moves in volatility. Prior to the wide spread use of dispersion in the equity options market it was a bit easier for institutions to make these kinds of pre earnings vega plays. The effect of dispersion on the market wide volatility has really eliminated most of the ability to trade the earnings volatility moves in individual issues.
  6. stfreak


    ratioed time butterflies
  7. So, what other strategies work well for profiting on implied volatility? What about buying a long straddle on a stock that's about to have a major announcement (outcome of a trial, approval of a drug, merger approval, etc.), and dynamically hedging (I'd always be buying the underlyer low, and selling it high, so I'd make a small amount of additional profit) it until just before the news release date, at which point you close out just before IV drops. Or would that run into the same problems earnings strategies run into?

    Basically, I'm interested in volatility arbitrage strategies. Isn't that the bread-and-butter type of trade that options market makers make, since they don't want to pick a direction of the underlyer?
  8. dmo


    Unfortunately, you're not the only one who knows that company is about to announce the outcome of a clinical trial, so IV will be high.

    As for volatility arbitrage - as a retail trader you cannot do volatility arbitrage, but you can do volatility spreads.

    But what I've been trying to tell you is that there is no - let me repeat - THERE IS NO ONE-SIZE-FITS-ALL STRATEGY FOR ANYTHING. There is no one thing you can do whenever earnings are about to come out and consistently make money. There is no one thing you can do whenever a clinical trial result is about to be announced and consistently make money.

    If there were, that would make it easy to make money trading options. And IT IS NOT EASY TO MAKE MONEY TRADING OPTIONS! Those of us who have been doing this professionally over a period of many years will tell you that it is damned hard work.

    I gave you good advice in my last answer. If you want to make money spreading volatility, then stop looking for easy answers and start studying volatility patterns. Maybe you'll see patterns, and maybe you won't.

    But if you've been watching the volatility patterns of certain events such as drug-company announcements or earnings over a long period of time, then every now and then you'll see one that is way out of whack. Then instead of getting sucked into whatever excessive excitement or complacency that is driving it out of whack, you'll take the other side. You'll bet against it. You won't make money every time, but you'll have done your homework, you'll be trading with real intelligence, and the odds will be on your side.

    There is no shortcut, sorry. If you don't want to believe that, then you are like most retail traders, and there are lots of gurus who will be happy to take your money to sell you their failsafe system.
  9. I understand...I'm not looking for a failsafe system, just some general ideas.

    Perhaps I should watch the IV charts of a specific stock, and enter a short straddle when IV is at its peak, like right before announcement of earnings or drug trials, then close out after the announcement, when IV plummets.

    Do you think options market makers made tons of money after the Bre-X scandle by profiting off the massive swing in IV?

    What's an example of a vol arb strategy?

    I plan on majoring in finance and minoring in compsci, so I can join a derivatives market-making firm at an entry-level position in their prop trading dept.
  10. dmo


    That's fine when it works. But what if you had shorted Dendreon (DNDN) straddles prior to a big drug announcement a few years ago when it was around 4 dollars. When the announcement came out it gapped up to 12 and a few days later topped out at 25. Ouch!

    Depends how they played it, but big spikes in volatility can be hard on market makers because they're the ones selling all that volatility as it's going up. It's their job to make markets and if the world is buying, they're selling. Maybe Xflat can chime in with an equity MM perspective on that.
    #10     Apr 1, 2009