How to structure trade for inverse indices

Discussion in 'Options' started by HFStartup, Jan 16, 2012.

  1. For some time now, I have been monitoring two indices (I'll refer to them as index A and index B) which are almost exactly inversely correlated; when one moves up by a certain %, the other moves down almost the exact same %. I will refer to the combined % moves of each index as the "spread." In other words, if index A move 1% and index B moves 1%, the spread would be 2%. Statistically, I can calculate when this spread becomes exagerrated and I would like to be able to structure and place a trade that will allow me to benefit when the spread returns to "normal" levels. However, I need to incorporate time decay (theta) into the trade which infers a net short trade, and I need to be non-directional (neutral) as well.

    Initially, this appears to me to be a question of trading volatility. If so, possible candidates are ratio spreads, selling a put and call simultaneaously on each index, butterflys, condors, etc. An additional complexity is added when the issue of whether to place a straight or diagonal trade is considered.

    Would anyone be kind enough to suggest an optimal trade structure to accomplish this? Any guidance for consideration would be appreciated.

    Thank you.
  2. rmorse

    rmorse ET Sponsor

    I might be able to help, e-mail me your contact information and we can talk Tuesday.

  3. Hi Bob. Thanks for your offer. Rather than talk offline, is there any way you could post your suggestion in this forum, so that others can benefit from your suggestion?

    Thank you.
  4. daveyc


    what are the underlying indices that you would like to trade the options on? are these etf's? off the top of my head and i am not an expert, the 'exaggerated' price in one index might not be reflected in the options market.

    just a quick note that you might consider or might not. you mentioned a theta trade, this is probably the least important of all greeks yet it gets all the attention.

    maybe you can attach an image of a potential trade here for posters to comment?
  5. It's a question of trading (option) volatility only if IV's are gyrating around.

    It's tough to suggest the "ideal" option position for this w/o knowing the magnitude of the daily ROC. If the A-B spread has risen to exaggerated levels (A has risen, B has fallen) and you expect a decent reversal, buying an ATM put on A and an ATM call on B would be the least complex way and most likely to succeed. If it's a slow moving A-B spread then this pseudo straddle would suffer from time decay. Anything that you add to offset that time decay could be problematic (butterflies, condors, ratios, etc.) and I would hold off on that complexity until getting the daily trading pattern sorted out.

    I would suggest that you observe and plot/record the intraday spread. If it oscillates enough intraday, you may have something tradeable. If it's a pure index, a problem. But if there are ETF surrogates, you can buy the undervalued one and short the overvalued one when the spread is inordinately wide (under/over valued being a somewhat subjective terms).

    Intraday you can shift your bias to one side if there's some recognizable metric driving price change such as rising/falling market or financials/oil/gold prices, etc. (add more to the long side or add more to the short side or conversely, reduce one side). You would then restore the balanced 1:1 pairing by day's end, closing it out completely if the A-B regression took the spread back to compressed levels.

    In order to augment such a pair trading system you really have to believe in the regression and be willing to add to the position when it moves against you because it's truly impossible to know where the maximum is. All you'll know at a perceived extreme is that you're a lot closer to the max than not.

    Hope this helps in some way :)
  6. I agree on the reflection. I think the objective is to take advantage of a reversal from exaggerated price.
  7. Truth is that no one is going to discuss rates or details over the internet. The prop business is very subjective and very few people will state outright what they pay or what leverage they have or what their arrangement is generally.

    If you have a hypothetical people are going to ask you to hit the bid.

    If you have a decent track record they might lift the offer.

    None of the sales guys or prop firms are going to say anything in public - Bob is one of the decent guys who chooses to post who he really is (provides contact details, phone number - real name) Half the n00bs around here are just looking to bait traders.

    In my opinion you should make up a fake strategy and pitch it to a few shops advertising HFT. See what rates you are offered. The experience alone will probably teach you something and if you don't get return phone calls from the bucket shops you probably aren't ready to open a HFT.
  8. IVtrader


  9. I'm not sure if anyone answered your question. I would consider doing either bull put spreads or bear call spreads on both instruments (depending on your view of the underlying). It would like a lot like an iron condor, with an advantage that as the instrument's spread reverts to the mean, the spread's target profitability would increase.

    A more expensive way to play would be offsetting covered calls (or selling cash secured puts). You would buy say 100 shares of each underlying, so you are effectively delta-neutral. Then write covered calls, with the strikes reflecting the expected reversion to the mean.

    Any thoughts on this idea?
  10. Daveyc,

    Yes, the indices are ETFs and both have strong option markets. However, one is much liquid than the other.

    With all due respect, I must disagree with your statement that theta is the least important of all the greeks. I have been using it as my primary metric for a trading system that has been consistently profitable over many years. Its exponential nature offers a decisive, strategic advantage to a trading methodology capable of integration.

    #10     Jan 16, 2012