Here is another trade idea that I am exploring. The Price of Correlation Riskwas discussed in April in Investing Notes on the CXO Advisory blog. The paper describes how the sum of the parts is less than the whole. What does that mean? The authors look at the SP100 and compare the index options to the sum of the constituent stock options. They conclude that the index options are more expensive than the constituents. One possible reason for that is that when markets make large moves the correlation of all stocks goes to 1. They move together, especially down. To protect against this correlated move, investors buy index options as insurance.
I am looking into this trade for QQQQ because the top ten stocks in the index make up almost 50% of the index. So you can capture most of the correlation with many fewer options. One of the killers of the trade is the transaction cost of buying so many equity options.
| Stock / Symbol | Percent of QQQQ |
| Apple / AAPL | 11.75 |
| Qualcomm / QCOM | 6.97 |
| Microsoft / MSFT | 5.06 |
| Google / GOOG | 4.58 |
| Gilead Sciences / GILD | 3.74 |
| Oracle / ORCL | 3.42 |
| Cisco / CSCO | 3.15 |
| Teva Pharmaceuticals / TEVA | 2.90 |
| Intel / IITC | 2.64 |
| Research In Motion / RIMM | 2.2 |
| ———– | —- |
| Total of QQQQ | 46.4 |
The way to do this is to buy the stock options in rough proportion to their weight in the index. So one would buy twice as many AAPL options as QCOM. Seven QCOM straddles for every five MSFT straddles. Then sell the dollar equivalent QQQQ straddles for the equity options bought.
I will test this out and let you know the results.
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