Hi Rudolf13100, My 2 cents. If you want to deeply understand the correlation between the both, you need to take a look at the correlation between the two underlyings.(dax as a european proxy for spx) As a matter of fact, managing a position like a long/short fund is really something very tricky. The usual outcomes are the correlation doesn't last the day you put your orders on. Managing long /short position on derivatives ones seems to be interesting but a very dangerous sport.
Hello Maw, I would say that the two underlying are well correlated. They move together but with different relative strength. Would the difficulty come from the fact that the spread between the two does not stay within a well defined range?
Correct.That's my own opinion. There is no such a thing. Correlation factor is just a past historical statistic, that means, no one would bet his life on it. The correlation between the two indexes is only a flow correlation. It's a very weak one. Thus, if for any reasons people don't think Dax as a proxy of SPX but prefer Mib, the relationship between (volatility) indexes won't last anymore. And your global position is only made by both. Hence, your prior aim to bet on the spread to reduce the risk is now a much more dangerous one.
Nice chart! Definitely shows a correlation, but it's hard to see exactly how far apart the spread gets. I would chart the spread itself going back several years. When it gets near extremes, you could definitely fade it and the odds would be on your side. Would I bet my life on it? No, but that's not the standard of proof or probability you're looking for. You don't need absolute proof, you don't need proof beyond a reasonable doubt, you only need "a preponderance of the evidence." All those multi-gazillion dollar hotels in Las Vegas were built on "house odds" - a few percentage points of favorable probability. A more difficult question is how you play it. If the Vix, for example, gets to an historic premium over the Vdax, you could sell spx straddles (or ES or SPY straddles) and buy dax straddles. I think that would be too complicated for you to manage at this point though. Another possibility would be to buy vdax futures and sell vix futures. For that, however, you must remember that the futures in this case float freely of the index (except at expiration), and the fact that the indexes are at a historically wide spread does not necessarily mean their futures are. So you would want to chart the spread between the futures themselves going back a few years, and base your trading directly on that relationship. And you would spread the futures at a ratio that makes them equivalent dollar amounts. Are the VDAX futures 1,000 euros per percentage point of volatility? If so, the ratio would be about 2 VDAX to 3 VIX. Unfortunately my stupid data provider dtniq provides the VIX index but not VIX futures, and VDAX futures but not the index, so I don't have the capability of charting that spread.
Hi Dmo, Interesting post, I respectfully disagree, so we may "swap" some points of view. " When it gets near extremes, you could definitely fade it and the odds would be on your side" Why? I mean how could you be reasonably sure that the odds would be on your side? Extremes couldn't be overtaken? " All those multi-gazillion dollar hotels in Las Vegas were built on "house odds" - a few percentage points of favorable probability. Right, but each day they got the sames. That's why large numbers law can be applied. Markets continuously change. "A more difficult question is how you play it. If the Vix, for example, gets to an historic premium over the Vdax, you could sell spx straddles (or ES or SPY straddles) and buy dax straddles. I think that would be too complicated for you to manage at this point though." What if the correlation stop? No problem with your long DAX straddles, but what about your SPY short ones? "Another possibility would be to buy vdax futures and sell vix futures. For that, however, you must remember that the futures in this case float freely of the index (except at expiration), and the fact that the indexes are at a historically wide spread does not necessarily mean their futures are. So you would want to chart the spread between the futures themselves going back a few years, and base your trading directly on that relationship. And you would spread the futures at a ratio that makes them equivalent dollar amounts. Are the VDAX futures 1,000 euros per percentage point of volatility? If so, the ratio would be about 2 VDAX to 3 VIX." It becomes a bet on volatility, a bet on correlation, a bet on currencies... That's a global bet! It makes me remember a pretty correlation bets fund called...LTCM. No risk to collapse. Cheers
Well sure the correlation could break down. Sure the spread could power through the previous high or low without pausing or hesitating there. But that's not typical behavior, not in my experience at least. Of course it happens, but if you're not going to fade the edges, the extremes, then what is your trading based on? Sure there are other approaches such as trend following, but that one doesn't work for me. That's not to say it won't work for someone else. But personally I like knowing historical parameters and fading them at extremes. Ah yes, LTCM. Those were the days weren't they, when a mere $4 billion loss threatened to bring down the whole financial system? Hard to believe it was only ten years ago. Well like LTCM, I lose money too. The difference (I hope) is that I practice sane risk management. That may change of course when I win that Nobel Prize. But really, the point I'm trying to make is not this strategy or that strategy. People come here to pick up helpful hints, and the best one I can give is to encourage them to use their own eyes and their own ideas and, above all, to trust their own powers of observation. The ability or willingness to do that is IMHO the number 1 trait that separates successful traders from their less-successful brethren.
"Well sure the correlation could break down. Sure the spread could power through the previous high or low without pausing or hesitating there. But that's not typical behavior, not in my experience at least. Of course it happens, but if you're not going to fade the edges, the extremes, then what is your trading based on?" A simple one. I gamble volatility bets (old school delta hedged vanilla spreads) on underlyings with the less correlation I could find. It doesn't mean there is no correlation, it means I don't play it. Each underlying is managed with its own risk/reward. Sometimes I earn money, sometimes I lose. But I'm still alive. "Sure there are other approaches such as trend following, but that one doesn't work for me. That's not to say it won't work for someone else. But personally I like knowing historical parameters and fading them at extremes." Make no mistake, I'm THE worst trend follower in the world (I may deserve an article in Forbes for that). That means you can make money if you do exactly the opposite position I take as a trend follower. It's definitly not a way for me to trade. "Ah yes, LTCM. Those were the days weren't they, when a mere $4 billion loss threatened to bring down the whole financial system? Hard to believe it was only ten years ago." Yeah, without talking about so called Nobel prized managers, it has been built on correlation strategies. There are a lot of examples of so called "market neutral" funds collapses. They always seemed to reduce risk by a long/short strategy. Sometimes... BTW, there no such a thing than a Nobel prize in Economic sciences. It's The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. "Well like LTCM, I lose money too. The difference (I hope) is that I practice sane risk management. That may change of course when I win that Nobel Prize." I agree. Since risk can be divided in two components: uncertainty and exposure, and since we are not always able to deal with uncertainty, exposure is and keep being the component we always are able to manage.The size of each position has to be fitted in term of consequences. If you win that Nobel Prize, stop trading and do lectures. You will earn much more money ( as they actually do).. "But really, the point I'm trying to make is not this strategy or that strategy. People come here to pick up helpful hints, and the best one I can give is to encourage them to use their own eyes and their own ideas and, above all, to trust their own powers of observation. The ability or willingness to do that is IMHO the number 1 trait that separates successful traders from their less-successful brethren." I agree (twice). And your posts are useful and helpful.
In essence it sounds similar to trading a currency pair, say the eur/dollars. We would sell the euro and buy the dollar following the rationale that historically the euro is high relatively to the dollar. Am I missing something? If we didn't want to take the currency risk we could hedge it by taking a position on the curreency future or the forex, no?