No, that's not what I said. When I say "risk premium" it's a generic term for "little extra" you'd have to pay to protect yourself in the market. To name a few, just in an index, it could be gamma (straight-forward option convexity), term structure (additional slope of the term structure to compensate for future shocks), short-dated skew (response of realized volatility to market direction), long-dated skew (cost of spot-vega convexity) etc. The idea is that you find which risk premium is overpriced against another risk premium and what ratio to trade one against the other. Let's take an example - you might want to sell short-dated ATM volatility and buy long-dated skew against it in some sort of ratio (usually, the ratio would be such that spot-vega convexity would protect you from the realized gamma moves). You are actually taking a view (yes, PREDICTING) that short-dated gamma is overpriced against dVega/dSpot convexity and hopefully you'd have some sort of a smart statistical model to tell you so. Once you develop the relative value thought process, you find that these trades/strategies are fairly easy to construct and evaluate with some simple statistics and some common sense.
Hi Mav, I am not trading this way, just exploring it. My bread and butter is totally different kind of trading. I am trying to find a good "hedge" for selling naked options. Taking a loss obviously works, but I still prefer to have the position protected. Spreads are of not much help. Futures as you and others pointed out, while might be helpful are far from being great, yet they are the only "hedge" that I see so far. Any other ideas? Your replies are very much appreciated. Thanks, redduke
Shorter-term short positions, more centrally placed, hedged by longer-dated, lateral long positions, with net long/short neutral or biased net long contracts is the most traditional, options-only hedged situation. You can continually hedge with short options, but you'll soon see that your account needs to be sizable to tolerate a fairly strong trend.
A good hedge for naked options is a wife or partner who doesn't mind living in a car after you blow up your net worth.
Even if I decide to sell them, it will be a small portion of my capital, so will not be living in a car if you can share your other "hedge" ideas here , it is appreciated.
Good. Remember that the further away your long options, the more the position acts like a a naked short position. I think that's what you're leaning towards anyway, so be sure to trial different strike distances. No need to have your long positions so tight that your daily mark-to-market is flat in an adverse move. You simply need to be able to ultimately recover. Be patient. Give the position time to come around to your initial estimate of what was supposed to happen. You'll likely have to add other positions during the length of the trade, but with your long strikes, you've got some mitigation working in your favor. You'll also have to be aware that an index will behave differently than an individual ticker.
Lots of homework that for sure. I am only interested in FOP on ES. Just curious, are you trading/traded this way?