just saw this thread for the first time... I am runing something similar , short on the Index (Dow) straddle and long on all thirty components... But not 1:1 ratio
Actually wish I'd found the ET forum before I started trading this strategy. In some ways it has opened my eyes to the nuances that have been spoken of about the broad strategy of volatility arbitrage. My whole thinking in this strategy, was first of all, I wanted to be net seller of premium. BUT, I wanted to have a cheap way of hedging for that eventual day when the fit hits the shan, with premium selling strategies. So, my brain came upon this idea of what Riskarb calls a iron butterfly replication. I was psyched to hear him describe it that way, because that's the way i saw it too. Another way to look at it though, after reading up on this thread from a year ago, as well Egar's, is that it is a "reverse dispersion trade" combined with a regular index short iron butterfly. Although good to know, I'm not sure this was exactly my intention. I've always thought if I was purely selling premium (but not wanting to be naked), I would like an Iron Condor better. On the dispersion trade, the more I study it, and from what I've heard others say, the positive dispersion strategy is likely to be profitable more often, is easier to trade (just look for outliers, sell partial profits, and stop loss the rest), and offers a smoother ride. It doesn't take much for a few outliers to really fu*k up a reverse dispersion strategy, and should only be tried some minority of the time when the difference between the index IV and the components' average IV is huge. So Mysticman, you were wondering about the thinking behind the approach, there it is. I actually hadn't done ANY thinking about trading regular versus reverse dispersion. When I first heard of it, it did not make intuitive sense why the regular way would work at all. But I've had an aha(!) moment over the weekend. Now I'm pretty eager to try it.
the "huge difference between index IV and basket IV" is fully compensated by basket ABS % change vs. Index's change.
So by your way of thinking, IV Trader, a reverse dispersion should never be done? Is there any conditions where you think it does make sense? I'm not being confrontational here, I'm not sure i disagree. Have you tried it both ways? (no smart-ass comments please)
it's not my way of thinking , it's a fact. Reverse dispersion can be done (when ratios = favorable to reverse , actually this month is one of them , very slightly) , but I always took the direct so far , because of my strategy of aggressive intra position adjustments ( on long basket). I'm just trading lessor unit of money this month.
Agree with your comments about +dispersion. However, when the difference between index IV and the components is huge, that is all the more reason to do + dispersion, unless I misunderstand what kind of difference you mean. IV_Trader replies that the "huge ifference between index IV and basket IV" is fully compensated by basket ABS % change vs. Index's change." Again I don't know what kind of huge difference is being referred to, but he is absolutely right that the basket % change is what is desired as the source of profit and the reason for doing the strategy. Historically index IV compared to index SV has been rich, so that is why you sell it. The trick is to find the equities to go long with. IV_Trader is doing a 100% replication of the index and that is somewhat rare. Usually you try to find the component IVs that are cheap to buy and try to replicate most of the index. There are two sources of profit -- the sold premium and the long outlier dispersion. Usually the sold premium is not major -- just enough to cover the cost of the long positions. So I don't think that the intake of premium is the reason to do this strategy. It is the potential profits from the longs that gives it the real kick. That is why the selection of components is most important. The short index options are just there to cover costs and provide a hedge, which is good, but they also limit profits somewhat. Still, it is not the homeruns but the steady singles that are important. Just my opinion.
When I first looked at the strategy, I had the opposite intuition. It did not make sense to me why reverse dispersion could work at all, given that index IV is usually rich, the nature of indexes themselves is to be relatively stable, while the propensity of index components is to disperse. Now I understand that occasionally there are special situations that can come about. However, most of the time when ratios are not favorable for regular dispersion, many traders just do something else rather than reversing.
The reason the +dispersion did not make intuitive sense was a just a blind spot in my understanding of options. More education, including a couple of months actually in the market solved the blind spot. One down, two million to go!
I see what you are saying , mystic. Is that what Egar suggesting and pros are doing ? To go long on components that have a favorable SV/IV ratio and short the Index ? Sometimes the partial (40-50% on 10-15 components) hedge toward the Index can be a disaster , especially if the Index went drastically up . I remember(from back testing) one month in 2004 (I think NOV ,after the elections) that 12 components vs. QQQQ had a catastrophic results : Index up big , but most weighed components did not ,because the QQQQ move was attribute to big move in mid cap (meaning the rest 50% that partial hedge left out)