Ok, 1st day to implement VOlatility Arbitrage after a good weekend reading. Let’s see how it works in real life.
(1) Fundamentally, mkt is bearish. Tapering causes Bond to rise, and fear on Equity market. Thus by fundamental, US indices should fall.
(2) YM and ES fell, but NQ rises due to some component’s good news eg. Tesla, Intel, and AAPL. CL4 is out of sync, NQ should be down at -xx, but is now +20.
(3) 15min NQ chart reached +3 SD, 15min AAPL chart reached +3 SD, 15min VIX is rising –> Reversal is near.
(4) Implied volatility of AAPL option = 31%. Realised volatility of AAPL = 24%, Expected realised volatility by Yang-Zhang estimator = 26%. Thus implied volatility is about 5% above realised volatility. We can trade on this spread between IV and RV. This will be a delta neutral hedged volatility arbitrage trade.
(5) GARCH(1,1) shows a spike above 10, and GARCH0 has spike above 5, showing overbought situation for NQ.
(1) We short 5 ITM calls and 5 ATM calls, near expiration AAPL CALL options.
ATM Call : 23082013 $510 (ATM) strike options, at interval of $0.50 average up the price of options, as AAPL continue to rise after reaching +3SD.
ITM Call : 23082013 $505 option (ITM). We average up at interval of around $1.00.
Average price of $505 AAPL option = $10.30
Average price of $510 AAPL option = $7.65
We expect that when price contract, ATM call will become OTM, and thus Vega and Theta will work for us well, and make the option price drop drastically. We expect to earn more from ATM call compared to ITM call. However, Gamma is working against us more for ATM call, where it is highest. Thus we want to compare whether ATM or ITM call will gain us more profit in this Arbitrage trade, by shorting both types of calls.
(2) To hedge the position, we Long 100 AAPL Underlying shares @ $511. We also long 1 contract of NQ E-mini @ 3095.
(3) To compare the effect of this Volatility Arbitrage strategy vs simple Short NQ E-mini strategy, we short 2 contracts of NQ E-mini @ 3095.
Upon market close,
$505 Call = $8.30. Gain $2.00 per option.
$510 Call = $5.90. Gain $1.70 per option.
Total gain = $1,850
AAPL Share = $507. Loss of hedging = $511-$507 = $4 * 100 shares = $400.
NQ closed @ 3075. Loss $400.
Net Arbitrage Profit = $1850 – $400 -$400 = $1,050.
Duration =1 day.
On the other hand, just shorting NQ alone,
NQ closed @ 3085, 3075. Win 30 points = $600.
Thus Volatility Arbitrage Net profit is $450 (or 75%) more than trading purely on NQ alone.
Note that for ATM and ITM call options we chose, the Vega is highest, at 0.21, and Theta (time decay) is also at its highest, around 0.80, both working favorably for our side. Gamma is working against us, highest at 0.024. Delta is around 0.5, but neutrally hedged.