Hedging Basis and Volatility Risk in Index Option Pairs
Summary
This document considers relative-value trading between options on two similar, but nonidentical, indices. Matching equivalent strikes may allow a position in one index’s option to be offset with an option on the other, yet movements in the indices’ basis create risk. The discussion assumes equal volatility and evenly spaced strikes for simplicity.
The responses distinguish a volatility-only signal from a combined volatility and basis signal. For a volatility-focused trade, the proposed approach is to hedge each index’s delta dynamically with its own underlying, aiming to isolate volatility P&L while managing basis exposure. When the signal includes basis, an offsetting long and short option position can retain exposure to both relative basis and volatility. The document offers conceptual guidance rather than a calibrated model or risk measurements; the suitable hedge depends on what the trading signal targets.
Key ideas
- A pair of similar indices can still have basis movements that affect option-relative-value trades.
- A volatility-only signal calls for separately managing each underlying’s delta and basis exposure.
- A combined volatility and basis signal can be expressed as offsetting options on the two indices.
- The hedge design depends on whether the intended signal concerns relative underlying performance or relative volatility.
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Full text
# Pair Trading Index Options # Pair Trading Index Options Suppose the trade is between Index Options of two Indices X and Y which are quite similar (but not exactly). So for the equivalent strikes, one can quote option on Index X and cover in Index Y. But these indices will have basis movements. How can one build a trading model to price options in say Index X based on Options of Index Y. How can one manage the risks. Assumption (Volatility of Both Indices can be assumed to be same). For Simplicity assume, they have equally spaced Strikes. ## Answer by onlyvix.blogspot.com (score 6) https://quant.stackexchange.com/a/7510 It really depends on the source of your signal. Since you're trading options I assume it is either volatility signal, or volatility + basis signal. If you have signal only on basis don't bother with options and just trade underlying. Now if you are trading vol signal only, you will need to hedge all basis risk - so gamma hedge (dynamic hedging with underlying) each underlying separately, so your PL on each instrument is (hopefully) just vol mispricing. If you are trading vol + basis, then you can implement them as offsetting trades - e.g. long 1M 25delta call in IWN and short equivalent call in IWO, no hedging (or just initial margin hedging) so this way you get PL from basis and from vol difference. ## Answer by Strange (score 3) https://quant.stackexchange.com/a/4268 Are you trying to trade RV in delta (that is, conditional out-performance of one over the other) or identify RV in volatility (that is, you want to cover a delta-neutral vol position in one index with vol position in another index)? You approach would be very different for these two trades.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.