That's right, except I am not sure what you mean by "short/long theta"... To me, it's all ticks and/or dollars that I pay/receive to get the trade on.
I would also highlight the other risks associated with the pair of your choice (MSFT - SPY). In general, the pure pair trade plays rely on mean reversion of the normalized price differences which form the pair. Mean reversion, however, is an effect often seen in cointegrated pairs. The less cointegrated the pairs, the less reliable the process of mean reversion. On the other hand, you're trading the volatility spread which would require one to analyze the cointegration of volatility (not price) differential of the pairs. I would not be surprised to find that the cointegration of MSFT-SPY (in terms of price and volatility) is poor. I would suggest that there are much better pairs with higher volatility cointegration. The other risk of your pair is that of individual company vs. index risk. The magnitude of your risk should be much greater when short gamma on the individual name when short gamma on the index. Instead I would rather eliminate this risk by trading with two index ETFs. These are just one of the things that come to mind. But overall good work on your effort.
Mart. Understand what you mean. Probably looking at a similar thing from a different angle. I dont always hold a position to expiration. As Corelio has just (accurately) pointed out, the trade is best described as a pair volatility trade, where I am more interested in the mean reverision of the IVs, than the actual movement of the underlyings. I dont always hold my positions to expiration, and when I put it on I look at the daily theta value as a guide. I try and be theta neutral or slightly net theta positive. I guess that would put me at somewhere around premium neutral total, I just havent looked at it that way before. Once my net daily theta starts to get into negative territory I usually look to get out. The question is though, are there any fundamental flaws in my way of thinking. My back tests results have been good to date. But that may mean I just havent hit the right pothole that exposes the flaw in my thinking.
Corelio, yep I completely agree with you, I dont actually use this pair, it was just a random example I threw in at the time. I havent actually tested any individual stocks, all ETF pairs so far. Shy if being short individuals. GS and BP have been very good examples of that.....
That's right. This suggests to me that what you have is a vol spread trade, rather than a pairs trade, which is exactly what Corelio was saying, I think... This means that you buy one straddle vs another and delta-hedge ad nauseam. That's an entirely different kettle of fish, 'cause there's all sorts of different moving parts to that. In my personal experience, those sorts of trades rarely work out.
Heres a real example of something Im looking at. Actually its only part of a basket trade but it will do.Ive ranked the SP100 based on IV percentile, taken the ones with the lowest percentiles so expect their IV to outperform other SP100 stock's IV's over the next 2-3 weeks. Looking at a basket of 5 stocks overall which should increase correlation to the market. I could sell the stocks with the highest percentiles, but dont like being short options on individual stocks so will hedge my positions with SPY. I plan to use a short strangle on SPY and long strangle on the stocks and keeping them delta neutral throughout the trade. One of those stocks is MRK. Ive calculated the Std Dev for the past 22 days (still trying to figure out how to calculate beta so this will do for now): SPY 2.8 MRK 1.4 Using the following setup, based on this Std Dev, I am hedged (theoretically) directionally according to gamma. Making some money on theta, but my vega numbers are way out. Seeing as this is a bet on Vega, I think I should be more balanced there. SPY AUG CALL 114 -145 AUG CALL 39 +100 AUG PUT 100 -120 AUG PUT 33 +98 GAMMA -892 1593 THETA 881 -205 VEGA -2480 574 Heres how it looks if I setup looking to balance Vega SPY MRK AUG CALL 114 -55 AUG CALL 39 +175 AUG PUT 100 -45 AUG PUT 33 +180 GAMMA -338 2851 THETA 333 -378.7 VEGA -942 1031 Basically Theta neutral here Basically premium (theta) neutral. Any comments on these 2 approaches? Possibly something else altogether?
Sorry, those positions didnt quite format as I expected them to. Using the following setup, based on this Std Dev, I am hedged (theoretically) directionally according to gamma. Making some money on theta, but my vega numbers are way out. Seeing as this is a bet on Vega, I think I should be more balanced there. SPY AUG CALL 114 -145 AUG PUT 100 -120 GAMMA -892 THETA 881 VEGA -2480 MRK AUG CALL 39 +100 AUG PUT 33 +98 GAMMA 1593 THETA -205 VEGA 574 Heres how it looks if I setup looking to balance Vega SPY AUG CALL 114 -55 AUG PUT 100 -45 GAMMA -338 THETA 333 VEGA -942 MRK AUG CALL 39 +175 AUG PUT 33 +180 GAMMA 2851 THETA -378.7 VEGA -1031 Basically Theta neutral here Basically premium (theta) neutral. Any comments on these 2 approaches? Possibly something else altogether?