This month I bought every Dow stock (except of GM) , sold covered ITM calls(for each) and bought DIA puts , I took the same position only ones before , what do you think ?
Its a delta play with a capped upside and crash protection on the downside. Should be great if we continue to rally.
yep , but actually I will make money if market goes up or down as long as all (or most) components will go to the same direction (collect IV difference from basket's calls and Index puts). Can happens in non-reporting month.
It has been made clear from the beginning that there are two types of dispersion trading -- regular and reversed. The reverse dispersion is usually not recommended or advisable, but because index options are now cheap and Profitaker wanted to look at it, we have been discussing it. There is a third scenario where the correlation between components and index is high yet that between components is normal or low. This leads to a usual distribution pattern whose mean is shifts with the movement of the index. Why would the component options not be hedged? It is not each component option position that gets hedged . . . -- it is the aggregate of all of them that is hedged.
Another reverse dispersion post. You need to clarify because I can't believe you spent all that money to buy the stocks. If you did, essentially you are short OTM component puts and long index puts, which I assume are also OTM. So then the question is whether or not you did this for a credit? (using the OTM puts in the calc) If you didn't you lose if the index does not go down.
Correct, Iâm long correlation and short dispersion. I too donât know what you mean here. The correlation between two stocks is essentially the correlation between the stocks volatility and it's direction. In a dispersion (or reverse) the components are hedged against the index and where you have 100% index replication I canât see any additional risks. Why would you want to delta hedge each individual stock in addition to being hedged against the index ? Perhaps you could better explain by example, so consider that just two stocks make up an index; <font color=#ffffff>..................</font color>Value<font color=#ffffff>.........</font color>IV<font color=#ffffff>.........</font color>Weighting<font color=#ffffff>.........</font color>Correlation Stock 1<font color=#ffffff>..........</font color>50<font color=#ffffff>..........</font color>10%<font color=#ffffff>..........</font color>0.5<font color=#ffffff>....................</font color>1 Stock 2<font color=#ffffff>..........</font color>50<font color=#ffffff>..........</font color>10%<font color=#ffffff>..........</font color>0.5<font color=#ffffff>....................</font color>1 Basket variance = 10% Index<font color=#ffffff>............</font color>100<font color=#ffffff>..........</font color>8% In the above example I would trade a reverse dispersion by selling the components IV and buying the index IV and arb a 2% profit. How would you âdelta hedgeâ that ? Why not just short DOW stock Puts rather than long stock/short calls ? Are they weighted so as to replicate the index ? Can you give us some numbers ?
To answer my own question, the basket vol is 9.903%. Finally got my head around the main formula; http://www.elitetrader.com/vb/attachment.php?s=&postid=905452
I must admit that this caused me to think a bit. Maybe I am wrong but I say this is kind of like being short gamma, you need to hedge your delta but really the best you can hope to loose as little as possible on your hedges. I agree that if realized correlation between the stocks really are 1 then you don't need to hedge, but what about a scenario where stock 1 goes up to 60 and stock 2 is unchanged. Assuming 3 months to expiry my back of the envelope calculations tell me that you then loose more then the credit you did the spread for. However if you do hedge your delta in both the stock and index on the way up you do make back some of you losses. Anyways, I am probably missing something but that is my thinking. (So much easier if you are long the dispersion - and thus short correlation).
You agree with who? Nobody has said that. Think about this again. You ALWAYS hedge. Correlation merely refines the hedge which is first of all and primarily based on volatility. It doesn't matter whether it is regular dispersion or reversed dispersion -- it is always the stocks vs. the index. In regular dispersion the index is overpriced and the stocks are not. In reverse dispersion the index is underpriced and the stocks are overpriced. Try not thinking of everything in terms of gamma. There are other greeks. Dispersion is a volatility play.
This is an update of the post showing the historical relationship between index and component volatility. For the Dow, the weighted implied volatility of the component stocks (WtdCompIV) is now 19.3%. The actual IV of the index (DIA) is 9.9%. One month ago the WtdCompIV was 22.8%, while the index IV was 12.9%. Recently I have started to look at the different weights which each component contributes to the WtdCompIV. Attached is a graph for the Dow stocks.