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Market MeasuresVolatility Arbitrage for Retail Traders? | Mar 21, 2019
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    Market MeasuresVolatility Arbitrage for Retail Traders?Mar 21, 2019

    A common trade used to reduce volatility and directional exposure is a pairs trade. To initiate a pairs trade, look for two correlated products and buy one while selling the other. Profits come from a reversion in the difference in prices.

    The S&P 500 and Dow Jones have correlated prices and implied volatilities but 82% of the time SPY has a greater implied volatility than DIA. This led the Research Team to ask, is there any opportunity in selling strangles in SPY and buying strangles in DIA? This trade would benefit from the IV differential while neutralizing the directional exposure.

    The Study:

    • 2005 – Present
    • 16 Delta Strangles
    • 45 DTE
    • Held to Expiration
    • Sold a Strangle in SPY while simultaneously buying a Strangle in DIA of the same Delta, thus hedging the directional exposure.

    Results:

    Although spreading the risk did lower the volatility and largest loss, the strangle pairs trade also had much lower profits. Additionally, the pairs trade introduced significantly complexity with order entry and management. Pairs trading outrights is a great way to reduce directional exposure and volatility, but extending it to strangles on two different products adds too much complexity with not enough benefits.

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