great posting , mystic. Would you be able to post similar doc before 11/21 ( DEC entry) ? I would like to paper test it. Attached is Excel P&L calculator that I made one and a half years ago before I started back testing. 1. Change input # ONLY in yellow cells 2. Column B13 never can be < 1 , mathematical impossibility when correl=100% 3. P&l numbers are at expiration day ,based on intrinsic values only 4. Notice the inverse relationship between IV Ratio(B10) and # of Basket's combos(and in some ways addressing the Gamma concern) 5. If B10 < B13 P&L CANNOT be negative Let me know if everything is clear here
"mysticman" needs to learn to read: index stock option does not equal stock index option. English is not an inflected language, and word order affects meaning. An index stock option is an option on a stock included in the index; a stock index option is an option on the index. Again, paying the bid/offer spread on any number of stocks included in an index--even the Dow Jones--would consume at least half your equity. There is also a reason why McMillan's books are required reading for MMs but not retail traders: MMs get the bid/offer spread and pay negligible execution costs.
the less components you using the more chances you have for ALL ( in your case 5) of them to be at the same side of the axis (all positive or all negative) by end of the month. Then the basket % change will always be equal the Index's , but you paid much higher vols for the longs that you received on your short (Index). But if 2 will be negative and 3 positive by the end of the month ...that's a home run
My two cents worth: Remember here that we're trying to do a tricky thing. We want a basket of stocks, like IV says, that provides a balance of relicating the movement of the index, but at the same time offerering the opportunity for a bunch of uncorrelated dispersion. This strategy tries to take advantage of the statistical notion that a stock is likely to a price DURING a period about twice as often as it is likely to close the period at or above the same price (Larry Mac's probabilty of touching versus probability of closing. Here's where all the nuances come into play: this can be a completely passive strategy, say using the Dow, and all 30 components, or using the S&P 500 and all 500 components (obviously only relevant for the well capitalized). Egar says use about 200 of the names, and just focus on cheap ones, but still maintaining the correlations of the whole index portfolio (this is a partial replication method). Remember that we balance the opposing objectives of hedging BETA, and still leave enough opportunity to generate alpha. My thinking on this is that the short index straddle is simply a means of financing the the long straddles on the components. You can take it or leave it. Or if you have a preference on how you like to sell premium, perhaps you don't like straddles, you like strangles, or condors, you can do that too. To some degree, it matters how lumpy you like your returns (IV Trader's method of perfect replication appears the least lumpy). The important thing is to make money. I myself like the active strategy of picking a small number of cheap, but liquid straddles, and shorting iron condors. They are less effective at hedging eachother, but the return expectancy appears greater. I am open to other views, however.
You can generate alpha with a 100% index replication if you produce a sufficient number of large, diametric outliers. If that condition is satisfied, you can replicate the remaining exposure with new atm component gamma[long neutral straddles].
IV_Trader, I know you told me to ignore this guy, but he keeps coming back with bad info from "back-in-the-day", and people who don't know better will be misinformed. Let's bring things up to date. The year is 2005. Options are traded electronically. I'll lay out the costs to do the full 100% replication on the Dow, like IV_Trader is doing, so people will have the correct idea about what the costs are. Looking now at the Dec options, the cost of paying for a 1 lot of all the Dow straddles is about 100 points, or $10,000. This would be the minimum amount required. That is one reason why some would wish to do only a partial replication. In addition you may be required depending on your situation to post additional equity to hold the short straddle on the index. The average spread for the 30 Dow ATM Dec options is about .075 (some are a nickel and some a dime), so the aggregate spread cost to do all the straddles is 30 x .15 = 4.5. This is the worst case scenario. If you split some of the spreads your likely total spread cost would be 3 points or $300. This gives a spread cost to equity ratio of $300/$10,000 or 3%, which of course is a far cry from the "half your equity" that our friend believes.
Vol Guy, I like your post for many reasons and wish to clarify what you are saying. It appears that you now favor the positive dispersion -- just the reverse of where you started. I agree with you that the main purpose of the short position is to finance the long straddles. However, when instead of short index straddles you sell the index wings, especially using condors, this drastically reduces your premium intake to finance the long comps. And there is no need to talk about doing this on the SP500 when the Dow and ETFs with much smaller components are available. The most I would consider would be the SP100, and even that would be stretch. Your comment about the greater odds of a stock reaching a certain price during the period before expiration is interesting. To take advantage of this, however, you would need to gamma scalp and adjust like IV_Trader is doing.
Good question alassio, but your example has more serious problems. The SMI may not be traded. You need an ETF to sell. The general idea is good, but you would have to check whether the options on these European stocks have enough volume so that the cost of the spreads is not prohibitive.
Yes, Mysticman, I have changed my position a little bit on pos. vs neg. dispersion. I've tried neg dispersion a few months, and can definitely see problems I didn't see before hand. I am a total newbie to options, but not to investing broadly. The outliers that are so necessary in the pos. dispersion strategy are killing me in the neg. dispersion. And there doesn't seem to be too many adjustment choices. If a short straddle on an individual name goes surpasses my premium taken in, what do I do? I think it's foolish to believe it'll reverse course. So I just seem to be watching one relative blowup after another. Like I said at the very beginning of my particpation on this thread. I haven't made mponey, but I haven't lost much either (2% over 3 months). I'm not so discouraged by this strategy that I won't go back to it at some point, but i have some more learning to do. And as I think you said, if the conditions are right for neg dispersion, maybe that indicates a whole other strategy besides dispersion althogether...Or maybe not.
Intermarket replication is a much less labor/expense/edge intensive option. Selling NDX/buying SPX otm puts and/or calls -- traded to a flat-outlay for long gamma convergence gains. Intermarket collars; long HGX puts/short HGX calls, long small futures. There are just two examples of a million permutations of vol-replication.