Risk Premia Pairs

The Rationale (The "Why")

In financial markets, correlated assets (like two stocks in the same sector) tend to move together. Think of them as being connected by a rubber band. While they can stretch apart temporarily, they usually return to their historical relationship. This scanner finds moments when that "rubber band" is stretched to its limit—specifically, when the implied volatility of one asset has become unusually expensive ("rich") compared to its correlated partner ("cheap").

This trade is a bet on that relationship mean-reverting, and is constructed to be short volatility on the "rich" asset and long volatility on the "cheap" asset, creating a market-neutral position that profits as the pricing dislocation between the two corrects itself.

How to Trade It (The "What")

1. This is structured as a pair trade, although the second half of the pair, the vega hedge, may be negligible (can be ignored when so marked.)
2. The main bet is the Fly (a butterfly spread) on the "rich" asset. This part of the trade profits from falling volatility.
3. The Hedge is a straddle on the "cheap" asset. Its cost is intentionally kept low, and its primary purpose is to protect the overall position from unexpected market-wide moves.
4. Your Maximum Loss (Max L) is the net debit you paid to enter the entire position.
5. Your Maximum Profit (Max P) is achieved if the "rich" asset's price finishes at the center of your butterfly spread at expiration; this is extremely rare, so profit is usually taken at 25-50% of that maximum. The primary profit driver is the normalization of the volatility relationship between the two assets.