Stratégies Options - Delta Hedged Risk Reversal Using French CAC 40 Index Options

CAC 40 September Future settled at 3128.5, in a range where could be experienced large variations, up and down.
A way to profit from large variations, both on implied and historical volatilities is to set a delta hedged risk reversal.

I – Situation

According to Reuters, "World shares eased and the dollar hit a two-month low against the Japanese yen on Tuesday, after signs of recovery in China's vast factory sector failed to offset worries about the health of the U.S. economy and the euro zone crisis.

But activity was limited with many markets in Asia and Europe closed for the May Day holiday.

U.S. stocks were poised to start the day mixed before data on the pace of growth in the U.S. manufacturing sector, with any sign of a weakening in momentum likely to increase talk of further monetary easing by the Federal Reserve.

However, many analysts expect the data to reinforce expectations that U.S. interest rates will remain on hold for some time. "With the economy still growing above two percent, calls for further quantitative easing (QE) will likely fall on deaf ears, at least for now," said Bill O'Neill, chief investment officer EMEA at Merrill Lynch Wealth Management.

The latest signs of weakening momentum in U.S. growth, which came from a sharp fall in business activity in the Midwest, saw the dollar hit a two-month low versus a basket of currencies on Tuesday at 78.622. .DXY

Against the yen, the dollar fell to a low of 79.64, its weakest point since February 21, while the stronger yen hit Japan's export-related equities, sending the Nikkei index .N225 to a 2-1/2 month closing low.

The MSCI's world equity index .MIWD00000PUS was down just 0.14 percent to 328.20, adding to losses of about 1.5 percent in April.

"In general, stock markets and risk assets seem to be extremely resilient in the face of the news flow which has undoubtedly been (of a) more negative nature," James Ferguson, strategist at Westhouse Securities, said."

II – The Strategy.

The very first thing one has to do when dealing with volatilities (implied and realized ones) is to estimate them.

■ Implied Volatility
When deriving Implied Volatility from option prices, it's usual to get values against strikes and maturities in order to build an Implied Volatility Surface

cac-40-option-implied-volatility-surface-2012-04-30

There is a large difference between 12% OTM Calls and 8% OTM Puts Implied Volatilities.

Using a future value for Sept Contract at 3128.50 that leads to take a look a the 3550 calls and 2900 puts.

■ Historical Volatility

III – Option Quotes

3550 Call can be bought for € 38.60
11 lots provide a debit of :
11 . 10 . ( 38.60 ) = € - 4246

2900 Put would be sold at 110.90
11 lots lead to a credit of :
11 . 10 . ( 110.90 ) = € + 12199

The net credit is -4246 + 12199 = € + 7953

IV – Expected P&L

In order to hedge the position against index moves, it's needed to delta hedge it using future contracts.
Here are both, Greek P&L set for the core risk reversal and the delta hedged one

P&l issus des delta et gamma speed theta & charm sur le CAC 40 échéance Sept 2012 au 30-04-2012

In order to delta hedge the position, 5 short futures had been added, sold at 3128.50

- SEPT 12 3550 call implied volatility is 23.94 %
- SEPT 12 2900 Put implied volatility is worth 32.61 %

risk-reversal-Profits-and-losses-2012-04-30

delta-hedged-risk-reversal-Profits-and-losses-2012-04-30

Next : Delta Hedged Risk Reversal Using French CAC 40 Index Options ( Update 1 )

Strategies Options