Building a Vega Neutral Portfolio

Hi Mark,

I am happy to see my questions and your answers.


Please explain, in a practical way, with examples how to move to a vega
neutral status when you are short vega, such as when you own an iron
condor.

Thanks a lot.


Antonio.

***

This is a very simple process.  You have positions with negative vega.  All you have to do is open positions with positive vega. 

There are three types of trades I recommend for adding positive vega to a portfolio:

Buy strangles for insurance

Buy calendar spreads

Buy double diagonals

Let's
assume that an investor owns 20 RUT August 370/380/580/590 iron
condors.  Here's how the Greeks looked at mid-day yesterday (5/28/2009):

2009-05-28_1233vega4

The call spread vega is -7.70 x 20 =  -154.0

The put spread vega is  -4.71 x 20 = -94.2

As expected, your iron condor position is short vega (248).

***

Buy strangles

Without
going into a discussion of how to choose which strangles to buy, let's
assume you want to own some July puts and calls to guard against a huge
move in RUT.

Assume
you choose to buy RUT Jul 560 calls (vega = 38) and RUT Jul 390 puts
(vega 30).  If you buy four of each, you pick up 68 x 4, or 272 vega. 
If you feel that's too much, you may prefer three of each.  Or you may
choose different strike prices.  The point is that when you pick the
strangle you want to own, you can buy an appropriate quantity to turn
your position vega neutral.

If your broker doesn't allow you to
see the Greeks for each option, then this is going to be more
complicated, but you can use an option calculator to determine the vega for each option.

Buy Calendar Spreads (Note if you
choose to buy a calendar spread that corresponds with the strike price
of the options you own as part of your iron condor, then you may (if
you sell the option you already own) convert the position into a double
diagonal.  DO NOT do that with your entire position, or else you will
be long vega.  The idea under discussion is to have a vega neutral
portfolio.)

Assume you decide to add some protection to your
portfolio by owning calendar spreads with strike prices that correspond
to areas of risk.  The calendar becomes profitable when the strike
price is ATM, and the resulting calendar spread profit can be used to
offset a portion of the iron condor loss.

In this case, you may decide to buy the following:

RUT Aug/Jul 390 Put spread

RUT Aug/Jul 570 call spread

Calculate
the vega for each spread and then purchase an appropriate number to give
you a net gain of however many vega you want to add.  Obviously 248
gets you vega neutral now, but there is no need to be that near zero
vega.

Buy Double Diagonal Spreads (or single diagonal spreads can accomplish your goal).

If
owning double diagonals appeals to you, choose appropriate spreads,
calculate the vega for each, and purchase an appropriate quantity. 
It's not a difficult process.  I'm not going to provide any examples
for fear some readers would take that random selection and decide it's
a recommended trade.

NOTE:  This method works for any of the
Greeks.  If you are uncomfortable with any portfolio risk – delta,
gamma, theta, or vega – there are appropriate steps you can take to
reduce that risk.  Obviously the simplest is to exit some positions. 
But there are appropriate strategies you can adopt to add or subtract
any of these risk factors from your portfolio.  Today, at a reader's
request, we considered some alternatives for adding vega.

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