Precisely my dilemma. So how to mitigate this vega risk is my problem. Consider the ff scenario. On nov 25th, 2008 the ESZ8 closes at approx 856. You expect that within the next 7-14 days the ESZ8 will touch either 790 or 965. You are unsure of the direction i.e. will it hit 790 or will it hit 965. I guess in simple terms, my question is: How can one use options to reflect this view of an imminent move to 790 or 965 from a current spot basis of 856 without having exposure to the vega risk? Thanks to all for contributing and sharing. Good fortune to all!
You are pretty much left with what dmo suggested previously or you could inverse the spreads mentioned in your other thread on exotics. That is, you inverse the condor or butterfly, which would have a reduced sensitivity to volatility. So you can buy a straddle, and then sell a strangle at the strikes, which represent your targets. You could also set up two long butterflies, which have the middle short strike exactly at your targets, but this alternative has a lot of legs and thus commissions and slippage.
So in sum: A. If I want to participate in market movement (i.e. long gamma) with vega neutrality, I can do the ff: 1. Reverse Double Calendar in a ratio that achieves vega neutrality i.e. Buy a front-month strangle/sell a back month strangle in a vega neutral ratio. So in my example I could buy Dec 790/965 strangle and sell Jan 790/965 strangle . I guess in the above example if/when the mkt trades to one of my targets i.e. 790 or 965 I would immediately exit the entire spread. Correct? Is that the best way to capture predicted profits? If the market trades to any of my targets, is it fair to assume the position would be profitable? What scenarios (if any) could I lose money even if it trades at 790 or 965 ======== B. If I want to play the range i.e. instead of expecting a quick movement to 790 or 965 I expect it will be BETWEEN 765 & 790 by opex, then I can: 1. Double Calendar: Sell the front-month strangle/buy a back month strangle. So in my example I could sell Dec 790/965 strangle and buy Jan 790/965 strangle . In this example, I guess if by Dec opex the market is within the range, I collect the premium from the expired Dec options and then exit the Jan options at the market. Correct? My fear hear though is that the premium collected form Dec opex even if the market stays in the predicted range may not be enough to compensate for vega losses in the Jan options. ===== Am I correct in the above comments for the two cases - A & B. Any further thoughts, ideas, warnings. Thanks so much.
Thinking about this further I know what I want is really a clean 'Up or Down" bet. Using my example on Nov 25, 2008 ESZ8 is at 856. I expect it to go UP to 965 or DOWN to 790 within say 14 days. I want to make money solely on the basis of this up or down prediction. I want no vega exposure and no delta exposure. Using exotic options I can just purchase a simple "Up or Down" option e.g. http://lo.betonmarkets.com/d//c_DropDownClaim.cgi?market=indices&w=CR&l=GB&by=underlying I would prefer to trade this on a regulated exchange as opposed to trading via betonmakrets.com, plus betonmarkets.com has a lot of restrictions. So my question, can I replicate this CLEANLY using vanilla call and put options? Thank you.
CP - you need to get hold of software that will model various scenarios so you have a solid understanding of how your position will act when this happens or that happens. You need to just sit there and play "what if" games until you've mastered it. This is a fairly complicated position to manage, so don't think you can do it successfully just by asking a few questions here. We can lead you to water, but at some point you're gonna have to make the tough decisions yourself.
I don't think so...because with a vanilla front-month strangle - the market can go to my UP or DOWN target and I can still lose money. So I can be right but still lose!! Or am I wrong in this assessment?
In this hi vol environment, your best bet for a bi direction move is a double fly as suggested earlier wherein your peak on either side are your up.lo targets on the sp. The hi vol ensures that the flies are cheaper than in a low iv situation. the prob w this dbl fly is that if the mkt goes to your taget during trade day + 5 with 20 more days to go you can't "monetize" the position since the payoff happens in the last 2 days. you might have to roll down/up or put on another layer of fly to cover the new sweet spots. Pretty hard to do. The dbl cal could kill you since you will be so long vega. you could buy 2 calendars up /dwon and sell the ATM cal for vega neutrality but you could get killed as well if ticker stays around short atm price. No free lunch i guess...
You have to choose different strikes, not as far out of the money as your targets, so that if the market makes it to one of your targets you'll make money. You'll just have to look at the different strikes and their prices and determine what strangle will produce your desired profit at your predicted target. The closer-to-the-money your strikes, the more your profit if the market reaches your target - but the more expensive the strangle and, therefore, the greater the risk.
with ratio spread you can get the same result on the same month long gamma vega and delta neutral but with negative theta