Home > Markets > Options > The problem with short gamma

The problem with short gamma

  1. We have seen markets enter a regime where there appears to be only one direction to price movement. A more accurate way to express this is to say that the return autocorrelation, or price mean aversion [reversion], is high. This was stated in another way in this thread:


    Textbooks on options trading will tell you to sell a straddle when you expect the vola to be low. Is this correct? What about in markets that have very little mean reversion and in one direction like we have seen for at least a month? Those sure have low vola. The answer is no, with an explanation detailed below.

    The problem is that models like Black-Scholes assumes that autocorrelation is zero (it assumes that markets are efficient, i.e., high AC would mean there are predictable trends), and that you should therefore trade as continuously as your trading costs make reasonable. Well, outside of MMs and high frequency firms, costs usually suck the big one and eat into any premium profit pronto. To add insult to injury, the premium you got was probably too little to finance the replication costs of hedging. [Remember, you as an option trader assume markets are efficient. If you don't believe it why the hell trade options? Just trade the underlying if you believe you can predict trends!]

    These two things taken together spell doom for any strategy that is short gamma in this regime for all but the most sophisticated, well capitalized, low cost structured firm/trader. If this structure is not true for you, guess what, you are also delta trading. :(
  2. What is even funnier to me is, option volumes are going through the roof, with equity volumes going lower.

    That means people are using options strictly for leverage.
  3. The problems with credit spreads is that you are selling an option whose vol is lower than the option you are buying.
  4. how? what if I sell an ITM call and buy an ATM call
  5. What I find interesting is that it seems like volatility can be low, but prices can move strongly over a period of time. Like I mentioned in an earlier thread, GS has moved from 155 range to 175 range so quietly few people noticed and I think IV and HV are real low.

    It seems like there should be better way to measure change and not just volatility. For a quick example, if a stock did this in the last 7 trading days:
    would you want to sell a 65 call for a low price just because the price isn't volatile?
    I'm not sure if I'm explaining this correctly, but there is more to price movement then volatility.

    Actually, Bernie Schaffer has an example like this in his book. Something like a strong uptrending stock was at $55 and a stock that went up and down quickly and was at $55 and that stock had way more premium, so it was fairly cheap to buy 55 strike calls on the stocks that was a strong uptrender. Interesting to think about anyway.

  6. rather timely statement nitro... I was just looking at options for the first time in a while and the prices seemed kind of odd to me.
  7. I just realized something. If it is true that the presence of return autocorrelation affects the volatility and expected value of asset price and BS therefore mis-prices vola [which in turn mis-prices delta/gamma], why not adjust the model such that we make vola functions of time to expiration and correlation coefficient, ρ? In this new framework the asset price volatility can no longer be expressed as σ^2t where σ^2 is the variance of asset price returns. Adding ρ would bias asset price volatility proportional to the autocorrelation coefficient as well as time.

    Is is as "simple" as adding ρ to this term, σ^2 ρt ?
  8. You just need to isolate which greeks are hurting your position and attack those first.

    If the market is on a break out, believe it, and then lean deltas in that direction. If you are more contrarian, when you adjust, bring yourself to delta neutral instead of 'bringing the deltas back into control'

    Consider some plays to hedge your vega on the downside, back spreads, ratios, long puts, ect.

    Might be a good time to hedge with the underlying, especially if you're trading something with a tradable future you can attack the gamma with.

    This environment has been difficult for people who like to set up a single short gamma position and then give it slight adjustments through time because the market just slowly grinds and blows right through an expiration loss point. All considered, I would consider some positions with a larger profit zone which may go infinitely in one direction such as a broken wing or imbalanced butterfly, diagonal spread, ratio or ratio write, or perhaps some straddle/strangle combos for risk-margin accounts.
  9. As I have mentioned to you before, nitro, it's all been done already. The whole point of stoch vol models is to treat volatility as a random variable. How to parameterize its behavior is the million dollar question with a whole variety of possible answers. You pick whichever one suits your view.
  10. There is much to be learned from examples such as yours, but it needs to be considered far more deeply and no one has thought through what I mean in this thread (probably my fault for not being clear).

    From Peter Carr. This is what I mean:

  11. of course they do. The new game in town, every failed stock day trader has overnight become an options expert, you did not notice that? Very soon I expect most bucket fx shops to also offer fx options. Look at Saxobank: Do you think that 15-20 pip spreads in even the most liquid option pairs deters some of those idiots from trading them? Promise people lottery like pay offs and you are guaranteed to have takers, from the beginning until the end of human kind.


  12. Books tell you that the only unknown in options trading is volatility, and that if you can predict this better than others you will make money. That is a bunch of shit. Look at the above example from Peter Carr.

    "Volatility" (the actual volatility you experience) depends on your hedging strategy, which in turn depends on the path dependency of the underlying.

    There is no way to get around trading delta unless you have access to sophisticated instruments like hyper options or [co]variance swaps.
  13. well, thats why a lot of professionals dont hedge greeks based on implied vols but on other measures of vol, a basic example being realized vols. It creates more variability in your p&l curve but makes your final payoff a lot more predictable. Just my 2 cents...

  14. Vols are independently unpredictable. You can plan your derivative position to respond to a change in vol however you like, but the amount of implied vol stuffed in to BS or whatever pricing equation used is a variable without supply:demand, or any other market force. It's simply a stat.

    For options, you can have expectations regarding how various strikes will react to each other as vol change hits the market.

    Quants normally allow volatility a wide berth, and rightly so.
  15. +1 better explanation than mine above.

    It pays to understand to what vol large market making desks hedge and how their "end product" is parametrized. Not in order to be able to replicate or time their moves but to understand how your p/l evolves on delta hedged option strategies, on average being p/l= vega( sigma implied - sigma realized).

  17. That doesn't address the issue.
  18. I sort of mixed two issues into one and misled by mixing correct gamma/delta hedges when in fact it is all about when and how to hedge, period, not the amount of the hedge.

    My point and beautifully exemplified by Carr is that depending on your position and how you hedge, you see different volatility, and you are back to trading the underlying. This is true even in model-free scenarios and has nothing to do with stochastic vols.
  19. Even if I believe this could help (I have to think about it) AFAIK, there is no way to back that out from publicly available information. It may be possible to do with P/C ratios and open interest, but only in extremely crude form, imo.

    The last equation is also something you see in books, but is also grossly incomplete. When and how you hedge is everything when combined with the path the underlying takes.
  20. it actually does a lot. Hint: Imagine how you would hedge your short options. Would you prefer a mean-reverting, low auto-correlation environment or prefer stronger trends. Where would you hedge, how frequently. Especially paths in any other than the most liquid stocks are heavily impacted by market maker hedging activities close to expiration. It can completely determine whether a time series exhibits auto-correlation or not. Think about it.

  21. Did you read the post about Carr's example? I understand the idea of hedging at realized instead of implied, but I am not sure you understand that doesn't help - you are still thinking about how many deltas or gamma to do. I am talking about when and how. Should I hedge every time the underlying ticks against me?

    It depends on your position and on your outlook for the underlying, what you experience as "volatility." Your definition is bullet #2 below. It doesn't address the problem of not having to deal with correctly guessing what the underlying is going to do. You are back to delta trading.

    "The definition of volatility is itself volatile." - Peter Carr
  22. Uncertain Volatility

    Of the paths UUUU and UDUD, which path do you think is
    more volatile?

    • To a probabilist equating the word “volatility” to quadratic
    variation of returns, both paths have the same volatility.
    • On the other hand, to a statistician who equates volatility to
    the standard deviation of the terminal log price, the required
    estimation of the mean implies that the reverting path UDUD
    has more volatility than the trending path UUUU.
    • On the other hand, to an ATM option writer who does not plan
    to delta-hedge, the trending path UUUU has more volatility
    than the reverting path UDUD. This writer equates the word
    “volatility” to the ATM implied to charge initially.
    • On the other hand, to an ATM option writer who does plan
    to delta-hedge, the reverting path UDUD has higher volatility
    than the trending path UUUU. Again, equating the word
    volatility to the initial ATM implied, this writer knows that
    vega and gamma are more negative along the mean-reverting
    path than the trending path. Forgetting the tree, these greeks
    become relevant when one is uncertain about the magnitude
    of squared returns and the possibility of crashes.
    • Of course, an ATM option buyer disagrees with the seller on
    which path is more volatile and an OTM call trader disagrees
  23. i guess you actually do not understand my post. I addressed the when and how. I said "once you understand the position of market makers and how they hedge" then you understand also how and when YOU hedge. How many gamma and delta you hedge on your own position fully depends on your own models. If thats still unclear then you may wanna read a litte what Eun Sinclair has to say in his book. I think it addresses most of your questions.

  24. An option writer who "doesn't delta hedge" isn't a special case: he's just a delta-hedger who happens to only hedge at expiration.

    UUUU or other form of auto-correlation isn't a special case; it's only a factor for someone who calculates variance using monthly/yearly (rather than daily) samples. UDUD and UUUU would be identical for a delta-hedger hedging on a daily basis, of course.

    After reading through the thread... seems to me your primary point is that trading costs make hedging impractical for retail option traders. I really, really disagree with that. With futures costs at ~$5 all-in per contract, how is cost an issue?
  25. I don't really understand what you're trying to achieve here, nitro...

    If you're trying to say that vol is unknowable and unquantifiable (i.e. an "unknown uknown" using Rumsfeld-speak), I won't disagree. However, it's an impractical attitude, as it means we should all go home now and stop trying.

    A much healthier view, IMHO, is to assume that there's some sort of structure to the price and vol processes and to try to figure out how to describe it in incrementally more robust ways. That's the premise behind a large body of contemporary academic work in finance.
  26. I am not suggesting you stop trying. That is your prerogative. I made a simple statement about short gamma, backed by theoretical and empirical evidence from Peter Carr.

    Look at the example by Peter Carr as it explains what I am saying more carefully. I am saying that even defining volatility is a huge problem. It will depend on your position, and then what you experience as "high or low volatility" will depend on the underlying path.

    What I am trying to say is, trading vola purely is a pipe dream unless you are a bank and have access to exotic variance or vola swaps, or perhaps hyper options. Peter's example show this beautifully.

    In summary, you cannot escape movements in the underlying with vanilla options (or even simple spreads), and beginning traders should throw just about all options books in the garbage can that claim you can just trade vola statically even by putting on a spread and forgetting about it, especially from short gamma point of view in the presence of hedging. This is very dangerous misinformation.

    Since the buyside basically controls the underlying path, they control the volatility they experience in their own option position. That leaves open a path to a new manipulator, "hedge funds" that make markets in options. We have transferred the manipulator from the specialist to the option MMs. I am close to believing that you should not be allowed to trade both options and the underlying as a single firm, except for hedging purposes.
  27. i also am not purely sure what you are trying to suggest.

    I personally witnessed how in my prop group index vol traders forked out millions of dollars purely trading vol and skew. I have never met any traders that were more anal about being delta hedged and never overheard more discussions about which approach they thought were most efficient than from those guys. The index options they traded were all exchange traded. I know for sure that the most exotic instrument they traded was var swaps, which actually is far from being exotic, and can be replicated very easily.

    Of course did those traders adjust their hedges, nobody suggests to leave hedged positions untouched, I am not sure where you try to get to.

    And the buy side...that is you ...buddy among all the other market participants, and yes, we all do directly influence the underlying path. So what?

  28. I completely disagree. Defining volatility is not a problem at all. There's a definition out there that the mkt unanimously accepts as the right one. Saying that everyone's personal experience of volatility varies is an entirely different kettle of fish. Ultimately, you (and Carr) are simply saying that investors' objective functions (i.e. ways of measuring utility) can and do differ.
    I don't really understand what you're trying to say here. In general, I have stated my view on short gamma strategies many times.
    From my experience in the mkt (not equities, though), the buyside doesn't control the underlying path, not in the grand scheme of things. Occasionally, they might, but those times are few and far between. I can tell you a lot of stories about BSDs that thought they were so big they could tell the mkt what to do. Most, if not all, of these characters are not in the mkt any more. So I don't buy this "manipulator" theory of yours and disagree with the restriction, as it makes no sense to me whatsoever.
  29. Index options are a different animal. For one, many of those are pit traded, and you can see the flow coming into the pit and calibrate accordingly. Very difficult for a single firm to control the underlying as well (although in this light volume environment it may be easier than I think). This is probably your experience and it makes sense that your point of view is such. I also have experience with MMing index options (SPX). Single equity options are what I am talking about, or even index options (ETFs actually) if you don't have access to option flow, i.e., you are in a pit.

    But even with that explanation, you are keying on my "complaint". READ WHAT PETER CARR SAYS AND EITHER YOU AGREE WITH IT OR NOT! Forget about what I am saying. First let's see if you agree with that or not. Then we can move to my "complaint".

  30. I would say this: volatility is easy to define, but there are numerous different definitions that can lead to confusion. In the context of what you're talking about, you *have* to define volatility on the basis of how often you delta hedge.

    If you put on a straddle and *do not delta hedge* until expiration, but manage to lose money despite low realized volatility... then the model is not broken, but your understanding of it is.

    If realized volatility is lower than IV as calculated using end-of-day prices, then you would have made money regardless of final price if (and only if) you had hedged on an end-of-day basis. If you do not hedge on a end-of-day basis, then what Bloomberg or other sites/services pass around as "realized volatility" is irrelevant to you.

    The realized volatility of *your portfolio* = sqrt(log return from day 0 to day T). And if this number is larger than the IV of your original position, you will lose money.
  31. 1) I agree with Martinghoul in that there are clear definitions of volatility which most participants can agree on.
    2) most index options are purely electronically traded, no pit involvement
    3) I also dont subscribe to any sort of "manipulation scheme". The market as an aggregate dictates price action but liquid indexes and their futures are simply too large to be manipulated by single entities. I am slowly getting your whole point is to steer others towards this manipulation argument, be it only in single stock options.
    4) Your first point in this thread was your complaint that BS assumes zero auto correlation. Guess what BS suffers much larger deficiencies from some other assumptions. So what, everyone knows it and treats it accordingly.
    5) It does not matter what UUUU or UDUD means to you. After UUUU the next sequence may be UDUD. The question you need to ask yourself is what you gonna do right now about your position. I suggested it does not pay to look at the past, it pays to understand what the position of the market currently is and depending on that whether those who hold large options positions have a motivation to hedge more or less frequency and at what levels. This is often very unclear and muddy but sometimes it can make a huge difference in your own hedging and price assessment.

    6) According to you, "My point and beautifully exemplified by Carr is that depending on your position and how you hedge, you see different volatility, and you are back to trading the underlying. This is true even in model-free scenarios and has nothing to do with stochastic vols."

    -> you have it the other way around. How you see assess volatility determines your hedges. And this heavily depends on your models, in effect you dont trade the underlying you trade your model. So we see things different even from the start.

    In thus I dont see a point to digress further unless we can agree that hedges are a function of the assumed volatility and not the other way around. Again I think your whole point is the manipulation scheme and I see where you try to get to but I simply disagree...

  32. Options are four-dimensional--deltas are influenced by volatility, time and gamma. That said, one can reverse gamma scalp using short straddles by maintaining a delta neutral to delta bias (in the direction of the trend). I have been all over this, and let's face it, directionality cannot be ignored. Let's assume that the only strategy in your arsenal is the short straddle. Let's say you know that the underlying will stay within the break-even area (ATM strikes +-total premium received). Do you make any adjustments? Theoretically, no. You know this trade will be a winner, but you do not know how much profit you will make. McMillan suggests an aggressive treatment here: Buy back the winning short option if it has lost 75-80% of its value. Then, any rebound will allow the other short option to be more profitable. Now, suppose you know the underlying will be unidirectional and will exceed your break-even points, but you do not know how far the underlying will go. One option (pardon the pun) is to not enter a short straddle-just skip this period. Two, actually go long or short, either using the appropriate option or the underlying--changing your strategy. Or, three figure out a way to make money with your short straddle. This may include exiting the short option with any bounce or pull-back and allowing the other option to run its course. Two, you can cover the losing option before it gets to the break-even point. Altho the ITM short loses money, the other short and the underlying make up for the loss. Three, you can either roll up/down the winners. Lastly, create an iron butterfly instead of a short straddle. Even though you are paying an inflated price for the insurance, it is worth it. Why? What if volatility jumps? The long put's value will jump and be an adequate hedge along with the short call. If volatility drops, then your short options lose their value quicker. You can even adjust the IB in ways similar to the short straddle.

    It is foolish to just trade one dimension (ie volatility). Directionality plays a huge part and must also be considered. Options are four-dimensional. Two, you can't just hold these trades to expiration. If you have a decent profit in the first three days, exit the trade and look for another one--there is no buy and hold in options either. Same as the underlying--you may buy and hold for days and at most weeks. Anyway, just my $.02, for the tuition I have paid over the past six years was much higher.
  33. There has been some good comments. Thanks.

    I am wondering, asiaprop, martinhoul, heech, jwcapital, which of you are primarily traders? Do you derive your income primarily or only from trading, or are you guys programmers, analysts, quants, etc in your firm?
  34. Trading, for my sins... But I used to be a quant.
  35. did market making, then traded prop for an ibank and now run my own small fund and also trade my own capital full time.
  36. All of the above?

    I just launched my CPO earlier this year. It consists of a black box trading application I developed/programmed, on the basis of my own model/view of volatility.
  37. Well done to all you.
  38. I concur...some good & smart folks on ET.
  39. I am no options expert. There are guys on here that understand greeks way way way more than I do.

    Personally, I have never found greeks useful. I use verticle credit spreads and sometimes ratio credit spreads to trade the futures market.

    To me the greeks are more of a way for mathematicians to understand what is going on and try to find 'optimal' methodolagies. In my extremely humble opinion they have no causal relationship to the option's behavior. Please correct me if I am wrong, just that in my trading style I don't feel like I have suffered from ignoring the greeks.
  40. If you're only looking at your positions on two days:

    1) the date you open them,
    2) the date they expire...

    The Greeks aren't useful to you. They really don't matter.

    The Greeks are only useful if you're trying to understand (and of course compensate/hedge) how your position value changes from day to day.
  41. I derive all of my income from trading. My main goal is preservation of capital with a return that pays my bills.
  42. They are important if you are interested in turning a potentially losing trade into a winner or even reduce your intended loss.
  43. I have resigned myself that in order to trade options in the way that I want to trade them, I must have an underlying model that works, and probably on the high frequency.

    It took some serious withdrawal symptoms and final acceptance through a painful process, but once flushed of the demon, it opened for some interesting ideas. I am now in the hunt for a high frequency underlying (stocks) system. I am pretty sure that I have a decent options system if I didn't have to worry about delta neutrality, but that is not my reality since I don't have access to variance or vola swaps. Starting from a simple premise as to how Rentec trades, almost all of the repercussions of an underlying HFTS must be highly constrained, so at least the search space is not infinite, or at least countable, aleph-null.

    “The greatest deception men suffer is from their own opinions.” - Leonardo da Vinci
  44. [​IMG]
  45. Nitro, are you employed now?

    Also, please enlighten me, why do you need var swaps to maintain delta neutrality?
  46. Right. A var swap wouldn't help you, if your goal was to buy/hold a straddle or any other type of static position. A trending but low volatility underlying would still blow you out.

    I don't think you really need to automate though. You really just need to delta hedge once a day, and then you'll get a pretty good approximation of having a pure-vol position.
  47. "...A perfect hedge with a constant aggregate gamma for all underlying levels would take infinitely many options struck along a continuum between 0 and infinity and weighted inversely proportional to the squared strike. This is etablished rigorously in Section 3.2. Note that this is a strong result, as the static hedge is both space (underlying level) and time independent."

  48. Ok, let's simmulate it. Come monday, I will give you a calendar straddle making you gamma short (short front month long next back month). You hedge the position delta once a day at a predetermined time, for a week and see how you do. You don't get to adjust the straddles strikes.

    You up for the challenge?
  49. Variance swaps are a great vehicle it seems for pure volatility trades.

    How can one get access to these instruments? Hwo liquid are they?

    What houses are the major players for these OTC instruments.

    Why doesn' the CME or EUREX create exchnage traded versions of variance swaps?

  50. VSs are an institutional product. Even when we were trading our measly $10M, we didn't have access to these things. I think these are strictly interbank agreements, AFAIK.

    In another thread,


    I proposed to the CBOE (and later to the CME because you will see in that thread that a futures on that suggestion is probably the only way) that they implement a product close to the spirit of a VS.

    If you are managing >$100M, I suspect you can call GS or Citadel etc, and get a quote on a VS on a given asset in denominations of $250,000 or more (probably way more).

    The point is that there is no product in existance, with the exception of possibly VIX, that allows you to trade volatility purely without having to worry about continuous delta hedging or skew risk. What we want is a sort of VIX for each individual equity, but VIX is too messy because it mixes months (there should be seperate "VIX" per expiry month withoug mixing options from different months), although I would even be willing to live with that.

    VSs are great because they in one price make an entire continous option chain liquid, and they are far more immune to the underlying than things like strangles and straddles
  51. Thanks nitro.

  52. Hi nitro,

    As a trader who used to price variance swaps, I don't get it.

    Since you quote a variance swap, you need a lot of vanilla strikes to construct a portofolio that would replicate the variance payoff. You need to delta hedge your vanilla portofolio to keep a pure volatility exposure. As a matter of fact, your delta hedging strategy costs need to be included in the variance price you'd quote. That's called a fair variance price that determines the strike of your variance swap. If you don't you would lose money for sure.

    Hence my point is the following one : if you 'd get a var swap, you 'd pay for delta hedging strategy in it. So delta hedging cost is not an issue here.
  53. Nitro, there are variance swap futures that are exchange traded. There are 3 and 12 month swaps on the S&P 500.
  54. I need single equity vola swaps, not swaps on the entire SP 500.
  55. I don't understand what you don't get. So the price of delta hedging is already included in the price of a VS. Great, I don't have to worry about staying delta neutral then, right? (other than that I paid for it.) And if I sell another month VS against one I am long, these two months delta hedging costs embedded in the VSs prices should more or less even out, and therefore I am trading just vola.


    Just so that we are clear, I don't want to replicate a VS with vanilla options. I just want a variance swap.

  56. I know, I was making the comment in reference to you saying they are only an institutional product. Also, making single equity vola swaps available is not your problem. They could all be listed tomorrow on the CBOE and that would not help you. The spreads would be 100 yards wide.

    Look, these are order flow products, not market taking products. If Goldman wasn't earning the spread on these over the counter, I doubt they would make any money on them.
  57. Right, I was aware of the VS on the SP500 being exchange traded. I may be able to make use of them in some future project, unless they have the problem you state below, i.e., that they have enormous B/A spreads.

    Well, it is my problem, but your point is that the solution that I claim as my savior would not help because it would introduce another problem, they would be essentially not trade-able do to enormous spreads.

    Ya well, that would not surprise me that there is no interest in making markets on them, for a variety of reasons which I don't want to get in to (I don't want to get into a political war with the powers that be). But I don't know if I agree with your premise anyway. People made the same arguments when options first came out at the CBOE ("who would sell insurance on equities? You have to be crazy!"), and now look, we have penny wide spreads in a large portion of the equity-option universe and the penny-pilot program is growing every couple of months.
  58. And what would this prove, exactly? What if I was profitable a week, or what if I was negative after a week? The former indicates I was right, and the latter indicates you were?

    That's not the case, of course. It will be profitable if realized volatility was less than IV, and a loser if realized volatility was higher than IV.

    FYI: I'm trading $2.5mm, and this property of volatility is a key aspect of my strategy.
  59. Well, I am not saying it would prove something or nothing. You claim you would be "...profitable if realized volatility was less than IV, and a loser if realized volatility was higher than IV." Ok, let's see if that is all it requires, by your own hand. We will have a measure of IV and realized at each hedge. We can wave our hands in the air all day long and mentally masturbate back and forth on ET all day long, but nothing beats a real-world test, even if that test is humble. I have done this thousands of times on real positions and I am telling you that is not all that it requires, but we keep going back and forth in circles like insane people.

    My claim is that the PnL will be dominated by how well you delta hedge, not just by IV vs realized vola, but because of every argument I have made in this thread and in particular, Peter Carr's insight. As soon as you introduce a non-trivial position that includes both puts and calls, long and short, multi-month options, you are extremely sensitized to the non-linear path of the underlying.
  60. No reason to do anything as complicated as a calendar spread. Just do a single option; if it holds for one option, it will hold true for any combination of options.

    We'll just do something simple. SPY (closed 116.58). I'll use SamoaSky's OptionOracle for simple pricing.

    Let's pretend Friday afternoon I sold 10 contract of the 117 Apr10 call, trading at 1.50/1.52. Premium: $1500.

    Delta (according to OptionOracle) 46.82. I go long 468 contracts of SPY, and I'm delta hedged. Cost: -$54559.

    Cash account: -$53059.44.

    Theta (with current IV of 15.44%) is -4.15; if underlying doesn't move, I would be out ~$124.50 on the option position by Monday afternoon.
  61. No!!!!!!!!!!!!!!!!!!

    You don't understand. It has to be a complex option position. Dude, we have been talking about a Variance swap that essentially simulates an infinite number of strikes, and now you say it doesn't have to be a complex position?

    Forget it. I don't have time for this.
  62. LOL, okay, I didn't realize you were so busy.

    Feel free to break down your calendar spread by calculating delta of each leg, and take corresponding position in the underlying. Newsflash: it adds up. The numbers work out in exactly the same way.

    The purpose of the *VARIANCE SWAP* is to build a static portfolio that doesn't require daily hedging. It doesn't mean that daily re-hedging is impossible or incorrect.
  64. My bad,

    I thought you wrote "I am pretty sure that I have a decent options system if I didn't have to worry about delta neutrality, but that is not my reality since I don't have access to variance or vola swaps."

    So where is your problem ? Delta neutrality ?

  65. spreads in var swaps on indexes are fairly tight. You can trade in the interbank pretty much anything from 25k vega units upwards.

  66. Yeah, call GS or Nomura in London. No problem :=)
  67. I dealt with them every day before I opened up shop myself, albeit in Asia, not London. Congratulations for knowing the name GS and Nomura.

  68. Amazing! Couldn't they find someone a wee bit more senior to teach graduate students? An associate, for goodness' sake...
  69. Martinghoul, you have recommended stochastic vola models in the past. Can you recommend a stochastic model (with jumps ?) geared towards equities in the public domain that can be [easily ?] calibrated, and has (C#/C++) software that I can run to test it? I know Quantlib has Heston and others, but I find that understanding what the parameters should be and how to calibrate it is hard going. I need a little more hand-holding at this point.
  70. Sire, since I don't really operate in the world of equities, I hesitate to recommend anything. All I can tell you is that the two main variants I use in my domain are SABR and HJM.
  71. FX?
  72. No, rates... I don't know anyone who uses anything more complicated than BSM in the world of FX.
  73. SABR and HJM are interest rate models, not used for FX.

    For Equities, different banks have different models. Heston (in its various forms) is one, but you really don't have to go with stocvol models, unless you are doing something very complicated. Depends on what your objective is? For simple stuff like exchange traded calls/puts/binaries, you can just use simple B-S with a skew and kurtosis parameters and after calibration, it should work fine.

    Define what your objective is ?
  74. but he is a french man teaching equity derivatives, that counts

  75. True dat... French, most likely arrogant and probably a graduate of Ecole Polytechnique. I am normally not one for stereotypes, but still...
  76. ...with the God-given ability to trade and teach equity derivatives

    Did you know that you have the choice to be completely covered by French-speaking broker dealers even in Hk, Tokyo, or Singapore?


  77. Right. I am making a big push to understand more sophisticated models. I have done some extensive research on my own trading, and I have come to a partial conclusion that most of my inaccuracies in replication come from not taking asymmetries in the pdf into consideration, leading to incorrect assumptions in both pricing and hedging in the presence of skew correlation.

    Finding mis-priced options/spreads in the presence of a model (my own) on top of a volatility model (Black-Scholes). Currently I back out implied volatility from Black-Scholes, which has proven to lead to the inaccuracies explained above. I am confident in my model to statically shed light on an edge, but it is the dynamics that give me problem to hold on to it. Peter Carr example that I describe in this thread is really revealing. Once you have a position, what you perceive as "volatility" is highly dependent on the underlying path, and completely different than if you had a different option position. There is no one definition of vola, only in the presence of a position does it exist. Implied Volatility is measuring something really fleeting, and some sort of average of that fleeting thing on top of that.

    There is no way to just trade volatility. In the presence of a skew, and a position that has puts and calls and mixes months, you are most definitely trading the underlying, no matter how much you twist and turn. Variance swaps could help to ditch the mean, but they don't exist as a unit for the retail trader, and replication is expensive.
  78. Just my two cents, the problem is even worse, you have to treat the portfolio as one big option, pricing each Call and Put and then adding up the values, does not work. The equations are non-linear, so the solutions do not add. Basically have to value and hence derive the greeks for the portfolio as a whole. Then the vol you use has to be your best guess of what its going to be over the remaining life but adjusted for the way you plan to hedge.
  79. Right, that is why you want something like a VS. The whole is almost equal to the sum of the parts in VSs, so aggregrating accurate book risk is possible. This is attained by the inverse of strikes-squared weighting scheme. If strikes were continuous instead of discreet and you could put on an infinity of option positions on at these strikes, you would never need to hedge the underlying at all. Alas, that is one of the big problems with BS as it assumes that you can continually hedge, at zero cost.

    This does not go far enough. You also need to understand the options own sensitivity to the skew, which is also non-linear but can be approximated roughly so for small underlying moves and time. In the presence of jumps, the whole thing becomes incredibly complex.
  80. If there were continuos strikes and perfect dynamic hedging, we would either all be out of business, or trading long gamma.
  81. +1, there would be no need of options :p .
  82. Well, that is what a Variance Swap gives you, with the "dynamic heding" priced in. With a VS, you are no longer trading the underlying (mean), but something far closer to pure vola.

    There are still risks, but the mean is almost completely removed from PnL for a long stretch of strikes, as seen by the almost flat gamma profile.
  83. When you cut through all the posturing and buzzwords, OP's real issue is: he wants to sell premium but is annoyed the markets have sustained directional moves, thus he gets hurt more than he "should" based on stdev or some other simple measure of vola. But.. the market's <i>job</i> is to inflict pain on whatever strategies are popular. The fact that iv has drifted down for the past year means there are more premium sellers than buyers. All those sellers are at risk from sustained directional moves. So what's the market going to tend to do? An exercise for the reader.
  84. That is false.

    That is true.

    That is false

    Irrelevant in my case.

    In fact, the popular strategy has done extremely well. Buy stocks, sell calls against it. Not as well as, throw a dart a the WSJ stock lists page and just buy stocks, but then, that is only in retrospect.


    If you don't want to deceive yourself, your true measure of continued success is to compare your gains against some index that mirrors the way you trade, and then see if you have alpha above and beyond that index. If someone says to me, I am up 70% from last march, I would say, oh, you bought the SPY last march and shut down your computer, aye?
  85. Re buywriting, it's ~putselling (yes, there are second-order differences, don't bother) so of course it does well when the market drifts upward. Buywriters are hurt by market crashes.

    As to "up 70%" & etc., I agree with OP that performance against a benchmark is the correct measure -- for a mandate-constrained trader. It's less clear for someone trading his own account.
  86. Nitro,

    Have you ever done any cointegration or RV testing for VS trades?
  87. No. The reason is that I am data starved. But I think the new systems are looking at porfolio level and book level PCA and Cointegration/RV analysis.
  88. Variance is it's own little animal with a lot of fuzzy fur and wrinkles, so understanding how trade relative value there is a bit tricky. Now, for first order approximation, you can download the history of VIX, rescale it for the business day count and here you go, you got a rolling history of 1 month variance from the beginning of times.

    As a retail trader, however, you exposure to var swaps is a bit limited (unless you are running a fairly large book) and you are better off looking into relative value trading of VIX futures and options. There is like a tonn of things you could do there, from simple spreads and flys to fairly complex option strategies. If you add VXX and VXX options (or other VIX etfs), sky is the limit.
  89. Running a large var swap book is about as much fun as a root canal. Yes, you don't have the strike risk but there is soo much other stuff that comes into play (basis, convexity etc) and liquidity is nowhere near the vanilla options.
  90. "Introduction to SPX Variance Strips

    CBOE has enhanced its trading systems with a new technology called BasketWeaver that will enable market participants to trade a large and complex portfolio of SPX options in a single transaction. This basket of SPX options, which we are calling "SPX Variance Strips," is intended to replicate implied variance exposure and will be quoted under the ticker symbol VSTRP. The quoting convention for VSTRPs is similar to that used in OTC variance trading: prices will be quoted in volatility terms, and quantities will be in contracts that have a multiplier (e.g., $25,000 or $50,000) that represents the aggregate vega of the SPX options comprising the VSTRP. CBOE intends to make VSTRP trading available each trading day."


  91. If option traders assume markets are efficient, by the definition provided by you (why the hell trade options?), then any and all trading (by them) outside of the purview of market-making would involve cognitive dissonance. All trading would involve adding liq and anyone taking liq would be the dumb-money.

    Predictable trends? An corr of zero in dispersion would imply betas of 1 on components. Do you see that expressed in the stuff you watch? I don't.

    Let's make a fwd-test. You hold a portfolio of short flies and I'll hold the same port of long flies. Let's see who does better (held to exp, no hedging).
  92. Yeah, yet another waste of an effort - nobody really trades full strips that much anyway, usually people trade lower strikes or ATM against their var swap positions. I think they should have concentrated on giving exchange MMs an incentive to trade their variance futures instead.
  93. This has changed slightly. See above posts.
  94. Once you can correctly parametize the collective, future human psyche and also know the value of the parameters, the problem is solved. :D

    Good luck, Nitro!