How to decide on the proper way to set up a delta neutral portfolio for volatility trading

Let us say I want to do volatility trading. i.e I conclude that implied volatility is cheap and will rise. So I need to set up a delta neutral portfolio with long volatility exposure. I am looking to benefit when volatility rises, thereby increasing option prices and I want to hedge my directional risk.

So I can do this by either:
1.Buying call and shorting stock
2.Buying put and buying stock

Which one to use when?

 

Theoretically you should be indifferent. But in reality you should consider, financing costs, dividend risks (if American options), borrow costs, and ease of transactions (bid test rule, etc).

I generally buy stock vs shorting it. Because it's easier to cut the stock and I don't have to worry about borrow. However, for others, it could present a balance sheet problem. For me it doesn't.

 

Thanks. What do you mean by balance sheet problem? I am an individual trader, so I dont have any restriction against shorting. Are you talking about a portfolio manager for a pension fund that is not allowed to short stock? If you can elaborate please?

 

As a retail trader, the balance sheet is probably less of a concern in the two examples you provided.

But it would limit your capacity compared to buying straddles in a reg t account. And if you are big enough you can hit credit limits with certain retail brokers (basically amount of cash you are borrowing even if it is risk less) if you are running a lot of stock.

 

Got it, thanks. But is not the profit potential the double for a straddle position as opposed to :
1.long call + short stock
2.long stock + long put
3.long stock + short call

Based on this, does it make sense to make the initial trade always an ATM straddle for a vol trader?

 

The straddle is the most efficient expression of a long/short volatility view.

1:1 stock+option results in an over hedged position with regards to delta.

 

Thanks. I should have been clear. I did not refer to 1:1 stockption...More like a 0.5 : 1 for stockption.
My opinion is that the straddle is more efficient because it has double the vega/gamma exposure, is it correct way of thinking?

 

Yes.

 

No. because a straddle = to buying 1 share of stock and 2 puts.

 

Go with what this guy says. He knows a lot more than me.

Btw newwurlmdn, what is wrong with the double gamma, double vega concept?