Paper Trade -- Delta neutral SPY IV drop capture

Simulated trade to capture pre-holiday volatility drop in SPY

SPY 92.95 1000 shares

SDS 54.09 (2X short S&P500) 430 shares (see delta neutral calculation below)

SPY July 91 Call 2.97 Delta .68 IV 23.24

SPY July 92 Call 2.29 Delta .6 IV 22.07

SPY July 93 Call 1.69 Delta .51 IV 21.39 (this is the one I selected--has the most premium)

VIX 25.06

DISBA 27.45 (Deep ITM Split Bid/Ask VIX) -- VIX true underlying price

VXX 66.86 DISBA/VXX = .4105

Net Debit = 1000*92.95+430* 54.09-1690 (Sell 93 July calls) = 114519

In the absence of other market dynamics the $SPX option IV drops significantly on Friday, or the day before a long holiday weekend. If the options are not expiring that weekend any sort of trade needs to be delta neutral, otherwise the normal move of the underlying would dominate the P/L of the position. This position should be delta neutral--but would need to be rebalanced if the underlying moves.

When figuring out what the SDS position remember that the SDS tracks 2X the percentage move not the point move of SPY. Since the 93 call is providing -.5 of the delta and the SPY is providing +1.0 delta we need another -0.5 delta to be neutral. I think it is easiest to do the SPY --> SDS conversion in dollars -- we need the equivalent of 0.5*1000 = 500 short shares of spy for the hedge, which is 500*92.95= 46475. Since SDS gives us a 2x move we divide that by two = $23237, and then we divide by the SDS price, 54.09 to get the number of shares to buy = 429.6, rounds to 430 shares.

End of Day 1 results

The market sagged some. Final prices:

SPY 92.39 off 0.56 (0.6%)

SDS 54.8

93 July Call 1.45 Delta .446 IV 22.5 (up 1.11)

VIX 26.22 (up 1.18)

DISBA 27.60 (up .14)

VXX 67.76 (up 0.9)

Paper value of the position at day end was $114504 (down $15) -- the hedge worked well! It looks like the time decay of the option contributed about 0.05 per option $50 total to this result. In addition the SDS was short about 0.2% in achieving the ideal 2X move. Finally the move away from delta neutral as the call delta shifted things to a net loss for the day.

Because of the market action the option IV went up, overwhelming the time delay factor that would make it go down. The IV on the option moved almost as much as the VIX -- which is what you would hope would happen, this is the intent of the VIX index calculation, to show the IV on S&P500 calls.

To adjust the hedge: We now need -(1-.446) = -0.554 in SDS to balance the lower delta of the option. 554*92.39= 51184.06, divide this by 2 and divide by the SDS price of 54.8 = 467 shares of SDS.