I have been a equity index futures trader for about 18 months now in london trading spreads/ index baskets. I have been for some time tryin to replicate some of the strategies trading options but i am stuck on this problem: Is there anyway I can synthetically buy a call that pays out as a function of how index a outperforms index b ( i.e the spread) To price this option is not too difficult but I can't think of any clever way of hedging it using options/futures on the outrights I want to be exposed to the intraspread volatility i.e the variance of product (a-b). I have some interesting data if any options specialist is interested in some collaboration pm me thanks tom

Maybe I don't understand the problem, but why not long an ATM straddle in a and short an ATM straddle in b? Your payout is a - b, and until expiration, you are exposed to the volatility of a-b. But my solution is so simple, I suspect that I don't understand your problem.

oops, Just to clarify. Your payoff would be the change in the absolute value of (a-b), rather than the change in a-b, and you would be exposed to the volatility of a-b. If you want your payoff to be the change in a-b, instead of its absolute value, but you want exposure to the volatility of a-b, then I don't see how to do this, and I suspect it is mathematically impossible. If you want your payoff to be a-b, instead of its absolute value, you can long atm call in a, short atm put in a, short atm call in b, long atm put in a, but you will not then be exposed to the volatility of a-b.