33 lines
2.2 KiB
Plaintext
33 lines
2.2 KiB
Plaintext
Cl,apter 31: Index Spreading 587
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Volatility Differential. A theoretical "edge" that sometimes appears is that of
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volatility differential. If two indices are supposed to have essentially the same volatil
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ity, or at least a relationship in their volatilities, then one might be able to establish
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an option spread if that relationship gets out ofline. In such a case, the options might
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actually show up as fair-valued on both indices, so that the disparity is in the volatili
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ty differential, and not in the pricing of the options.
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OEX and SPX options trade with essentially the same implied volatility.
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Thus, if one index's options are trading with a higher implied volatility than the
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other's, a potential spread might exist. Normally, one would want the differential
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in implied volatilities to be at least 2% apart before establishing the spread for
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volatility reasons.
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In any case, whether establishing the spread because one thinks the cash index
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relationship is going to change, or because the options on one index are expensive
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with respect to the options on the other index, or because of the disparity in volatili
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ties, the spreader must use the deltas of the options and the price ratio and volatili
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ties of the indices in setting up the spread.
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Striking Price Differential. The index relationships can also be used by the
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option trader in another way. When an option spread is being established with
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options whose strikes are not near the current index prices - that is, they are rela
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tively deeply in- or out-of-the-money- one can use the ratio between the indices to
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determine which strikes are equivalent.
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Example: ZYX is trading at 250 and the ZYX July 270 call is overpriced. An option
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strategist might want to sell that call and hedge it with a call on another index.
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Suppose he notices that calls on the UVX Index are trading at approximately fair
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value with the UVX Index at 175. What UVX strike should he buy to be equivalent
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to the ZYX 270 strike?
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One can multiply the ZYX strike, 270, by the ratio of the indices to arrive at the
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UVX strike to use:
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UVX strike= 270 x (175/250)
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= 189.00
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So he would buy the UVX July 190 calls to hedge. The exact number of calls to
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buy would be determined by the formula given previously for option ratio. |