Hey guys, As per the title. What do you guys think is the best vega neutral UPSIDE strategy to put on if I simply want to be hedged against a slow grind higher as we are currently getting in the SPX. Black-scholes doesn't work very well for call vol skew in a slow grinding market in my opinion, as even though i'm hedged with lots of calls, the slow grind upwards kills the vega on my hedging calls coupled with the fact that they accumulate huge amounts of vega as the market is rising towards them. My stock portfolio position is essentially a ratioed short iron butterfly, but as the market grinds upwards towards the wings, which are usually ratioed (them being ratioed is a huge part of the problem) they gain a huge net vega as well as them being crushed at the same time by the falling implied vol. So what i'm after is an OTM upside hedge that has lots of long gamma potential but isn't susceptible to accruing huge amounts of vega. Any help is greatly appreciated. hardtofin
You can ratio a bull calendar (√time), and you benefit from Derman delta (stickiness/otm vols increase as they become local strikes/trade to 50D), but there isn't any need. You're long D, and earning from sticky-delta. Only risk is the vol-line. An OTM cal is going to be less sensitive to (inv-prop) vol-drop on rallies due to Derman. Keep an eye on the 25D risk-reversal. Time the calendar as the R/R increases (down strike vol/up strike vol).
Hi Destriero, many thanks for the post. Can you explain this a bit further please, i lost track a bit with your use of "/" in between terms. Are these and/or or aswell as etc? As i understand you are saying to go long a call calendar spread in a ratio so that my time weighted vega is neutral. Where do I place this, at the top end of my range where i want the hedge i assume? So the short strike is in the front month but carries more time weighted vega so i should buy more of the back month long? I didn't know what you meant by "inv-prop" or by (down strike vol/up strike vol). Thanks again for your help so far.
Sorry, like commas. I meant there is no need to ratio. Gamma and vega sensitivity are initially low. You'd be adding a haircut to the hedge in order to reduce vega. I'd rather be long vega than short gamma. The things going for an index bull 1:1 calendar: 1) ddrift of short call (gamma moment) 2) sticky delta gains as strike becomes local (spot rises--strike vol rises) 3) delta gains! 4) low ve-sensitivity Cons: 1) vol-line dumps (implicitly due to spot-rally); so not really a con. 2) short gamma (moot) More will come to me.
Basically an OTM bull index calendar is cheap vega and +sticky. Up and OTM strike-vols trade under ATM vols. UP and OTM strike-vols rise as they become local (spot rallies). If ATM vol is 15%; your OTM strike is 12%; then your OTM strike vol will increase to 15% as spot trades to strike. This assumes a static vol-line (area under the curve). Up and out strikes gain from skew. Their vols are lower than ATM. They converge to ATM vols as spot approaches the strike. I model the gains from sticky-delta as a wash to the loss to (VIX?) on an index rally. You're still earning from delta position. Going neutral vega requires a diagonal or a ratio. Why not be long delta AND some vega?
Regarding watching the 25 delta risky, can you elaborate on that bit for me please. Specifically the part "as the R/R increases (down strike vol/up strike vol)." What did you mean by that please? Many thanks for all your help so far destriero
We were at 22 VIX last week and the skew was flat. Ideally you'd like to buy bull calendars when there is a significant skew on the 25D RR. This is an example and does not reflect the current convexity: -25D puts :22% ATM: 17 25D calls: 14% RR: 8 Benefits of bull calendars: You won't be terribly concerned with your vega if you trade to your calendar strike. The vega on your flies is nominal and the only vega will be in your hedge. You'll earn more on delta than you can lose in vega in the hedge. Derman delta: calendar strike-vol will converge to (former) ATM vols as spot rallies, assuming a flat vol-line. IOW, you expect the calendar-strike to trade from 14 to 17%. The calendar is a passive hedge, so you're not concerned with delta decay and higher moments. Vol moves inversely-proportional to spot, but it's unlikely that you'll lose more on the vol-line (across all strikes--VIX) vs. gains from sticky delta. Microstructure is a bigger impact than charm and color. The gains from Derman are measurable and predicable. I wouldn't use bull calendars as a delta hedge unless there is curvature (skew) and implicit gains from stickiness. Or if vols are in the low teens on SPX. The good news is that the skew is defined absent geopolitical news as we have seen.
This is great! Thanks so much! One final question. You mention in an earlier post the timing of the calendar in relation to the 25d risk reversal. When is the correct time to execute the calendar in relation to the risk reversal?
So do you just keep an eye on the skew of the risky and as soon as it looks like it’s hit a peak put the calendar on then? Why is the skew on puts in the risky important for a calendar using only calls?