ok guys i have got my employer start a derivative strategy group… my mandate being generating a stable cash flows irrespective of the market conditions…with such a high volatilty with hefty premiums being offered I think short strangle are good way to make some decent RoI’s to start with…since hefty premiums give you a larger profitability range … i have modelled the delta/vega/gamma/theta impact in my model… my question is should i be more concerned about rho? since in the country I operate doesnt have an active debt market so I think its no use simulating interest rates… and also measuring the impact of the dividend yield… can i safely assume that the impact of Rho and dividend yield on my short position would not be a major issue? JDV and others any comments?
What are you selling strangles on, e.g., stocks, futures, fx, etc?
Anyway, the risk manager ought to pull the plug on this strategy right now. You just start a derivatives strategy group and out of the gate all you want to do is short gamma? I’d pull the plug on this in about 2 seconds with about one sentence (#2 above).
What’s a strangle?
strangle is a straddleish option strategy that you buy one put and sell one call at a higher exercise price, i saw them on a late night commercial.
Anyway, here’s my more complete take on this - “my mandate being generating a stable cash flows irrespective of the market conditions…” is darn near a cliche and I always roll my eyes when I hear it. What happens is that people get tired of being beaten up by risk by taking long positions so they think that derivatives is a better game. Of course, you move from a positive expected return for taking on risk to a <0 expected return with derivatives which occurs to people later. Managing risk in greeks is about 1/400th what you need to do to make money trading derivatives. The most important thing you need to do is to have market views that are best expressed in derivatives (and not “Wow, vol is really high” or “Wow, my simulations show me that implied vol is almost always greater than realized vol”). In the end, trading derivatives is a tougher game than taking on systematic risk. You need to ask: a) What are my market views? Are they structural or situational? b) Do I completely understand the derivatives I am trading? (If not, the quant at the bank does) c) What edge am I getting from the market (providing liquidity for some risk class, ability to inject lots of capital, better quant models, etc)? d) How does my portfolio work? (Derivatives groups without portfolio plans all suck) e) What risk management protocols am I following (gamma can eat your entire company)? f) Do I have the required infrastructure for this?
g) IPS?
I somewhat recall in the readings that a box spread will return the risk free rate… somewhat off-topic, but made me wonder if that’s the case, is there any advantage to using the spread versus just buying the treasury?
bpl1000 Wrote: ------------------------------------------------------- > g) IPS? Yeah, if you were doing it for one person but usually you just run a hedge fund and do the usual “qualified/institutional investor” thing. A box spread would return the risk-free rate until the expiration if there were no transaction costs which of course there are and they aer significantly higher than the costs of a Treasury. Otherwise it’s an arbitrage-type transaction.
For a box spread the goal is to capture a mispricing. If everything is priced correctly, the return should be the RFR. If you have things mispriced, the box spread will give you the RFR plus some amount that you’ll never have to pay back. So if there is no mispricing, just buy the treasury. If there is mispricing, a box spread should capture it. I don’t remember how you construct the box spread, but I do remember that that’s what it’s about. Now, of course, is there really a mispricing? You’d better be confident that you can pick it out, and just assuming BS pricing models doesn’t sound very right to me, since there’s dividends, early exercise, and fat tails all over. – In a strangle, you’re buying a put at a low price and a call at a higher price, so you’re paying two premiums. If the underlying stays between the two exercise prices, you get nothing and are out the premium. But if the market gyrates a lot, one of the legs is likely to expire in the money. It’s like a straddle, except in a straddle the exercise prices are the same. Separating the exercise prices in a strangle can reduce the total you pay out in premiums. Now if you’re shorting straddles, that means you’re selling a call and a put at the two exercise prices, and you just sit back and collect the premium if the market is quiet and stays between the two prices. But in choppy markets, you’re likely to have to pay out big on the put or the call (or worse, the put might get exercised early, and then the call expires ITM). Shorting strangles doesn’t sound smart to me in a choppy market. If you think that people buying strangles are driving prices up, then perhaps a box spread will capture it, but again, you’d better have a good theory/model telling you what the prices should be.
…what Joey D said… I always take his word to heart… never refute the zen master…