Add training workflow, datasets, and runbook
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Chpt,r 31: Index Spreading 581
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J!"<>r example, if one index sells for twice the price of the other, and if both indices
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have similar volatilities, then a one-to-one spread gives too much weight to the
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higher-priced index. A two-to-one ratio would be better, for that would give equal
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weighting to the spread between the indices.
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Example: UVX is an index of stock prices that is currently priced at 100.00. ZYX,
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another index, is priced at 200.00. The two indices have some similarities and, there
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fore, a spreader might want to trade one against the other. They also display similar
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volatilities.
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If one were to buy one UVX future and sell one ZYX future, his spread would
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be too heavily oriented to ZYX price movement. The following table displays that,
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showing that if both indices have similar percentage movements, the profit of the
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one-by-one spread is dominated by the profit or loss in the ZYX future. Assume both
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fi1tures are worth $500 per point.
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Market ZYX ZYX uvx uvx Total
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Direction Price Profit Price Profit Profit
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up 20% 240 -$20,000 120 +$10,000 -$10,000
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up 10% 220 - 10,000 110 + 5,000 - 5,000
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down 10% 180 + 10,000 90 - 5,000 + 5,000
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down 20% 160 + 20,000 80 - 10,000 + 10,000
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This is not much of a hedge. If one wanted a position that reflected the movement
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of the ZYX index, he could merely trade the ZYX futures and not bother with a
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spread.
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If, however, one had used the ratio of the indices to decide how many futures
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to buy and sell, he would have a more neutral position. In this example, he would buy
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two UVX futures and sell one ZYX future.
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Proponents of using the ratio of indices are attempting strictly to capture any
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performance difference between the two indices. They are not trying to predict the
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overall direction of the stock market.
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Technically, the proper ratio should also include the volatility of the two indices,
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because that is also a factor in determining how fast they move in relationship to each
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other.
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