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Introduction to the Greeks

The Greeks are easy-to-understand (honest) tools for measuring risk. You, the trader can delve into the math or you can accept the numbers generated by your broker’s (or use another source) software.

The basis of risk management is using the numbers to control the possible gains and losses from your options trading.

At my about.com site I just published a string of articles for newer option traders:

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What is Vega Neutral?

A surfer landed on this blog when searching for the phrase: ‘What is vega neutral?’
This is not a topic that I have discussed at Options for Rookies, and this is an opportunity to do .

Definition of Vega

In simple terms, vega let’s us know how much we should expect an option’s price to change, when the implied volatility (IV) of the option changes by 1%. Note: The term ‘1%’ refers to a change in the implied volatility from 30 to either 29 or 31.

When we sum the total vega of each of the options in a given position, vega tells us how much we can anticipate earning (or losing) when IV changes by one point

Using more ‘official’ terminology: Vega measures the sensitivity of the option premium to volatility. In other words, as the volatility environment changes, the value of an option changes.

‘Option premium’ refers to the real value of the option in the marketplace and the term ‘volatility’ in this context, refers to the implied volatility of the option.

Mathematically, vega is the derivative of the option value with respect to the volatility of the underlying asset.

Vega Neutral

Most individual investors and traders tend to trade with a market bias. They are bullish or bearish; they believe that the market will be quiet (less volatile) or exciting (volatile). They construct positions that earn money when their bias becomes reality.

Most professional option traders prefer to own positions with minimal risk, they build positions that are neutral in as many respects as possible.

Delta neutral positions are neither bullish nor bearish.
Gamma neutral positions remain delta neutral as the market rises or falls.
Theta neutral positions neither make nor lose money as time passes.

A vega neutral position has a total vega near zero and offers a hedge against a change in the implied volatility of the underlying. The trader who has a market bias that she wants to play, but does not want to be exposed to a loss if the implied volatility changes, makes a trade that is vega neutral.

It is important to understand that we option traders have the ability to control risk, and being vega-neutral is one of those ways used by more sophisticated traders.

Personal note: The positions that I trade are seldom, if ever, vega neutral.

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The Option Greeks and the Passage of Time

In one of my live interactive meetings with Gold Members at Options for Rookies Premium, we were talking about the passage of time and whether option premium (and thus, bid/ask quotes) were adjusted smoothly with the passage of time or whether they ‘jumped’ each morning as a result of it now being ‘one day later.’ This is a typical (good) question from someone who is new to trading options.

By the way, the answer to the above question is ‘neither.’ Other bloggers, including Mark Sebastian, have discussed this point in detail (Option Pit) , but let me say that market makers have a system for marking the passage of time. My guess is that each uses a proprietary method and that everyone’s timepiece would not read the same time. In simple terms, the ticking clock speeds up as we move from Monday to Friday.

Regardless of the specific details, the people who set the markets accelerate time decay as the end of the week approaches. In other words, the theoretical clock ticks much faster on Friday than on the previous Monday. Why would market makers do this? It’s an attempt to smooth out the passage of time when taking into consideration that the markets are not open for trading on the weekends.

If the option traders used the ‘true’ Friday theoretical values for their bids and offers, when Monday morning arrived each option would (assuming an unchanged sock price) be lower than on Friday. This would be especially obvious as expiration week arrives. To discourage others from ‘dumping’ option premium of Friday and repurchasing Monday, the passage of time used to determine the value of an options is not measured in real time – at least not as weekends approach.

Whether this is a good idea (no markets are open over the weekend) or a bad idea (wars can start over a weekend) is not the point.

That discussion brought us to more questions about how time affects other greeks (in addition to theta). Does delta, gamma, vega change as time passes? The answer is yes, it does. Most of the time, beginners are not introduced to these concepts because they are not important factors on a day to day basis. There are general themes that are important (such as how does delta change as expiration nears), but the details are often overlooked. The math gets complex, but as will all math used in the options world, we have calculators to do the difficult tasks.

With that background, I believe it’s a good idea to introduce you to some of the second order greeks – with the understanding that this is basically a FYI discussion. If you want to get a deeper glimpse into the world of risk measurement when using options (the greeks), read on.

The following is from Wikipedia

Higher-order Greeks

Charm

Charm, or delta decay, measures the instantaneous rate of change of delta over the passage of time. Charm has also been called DdeltaDtime [the rate of change of delta with respect to time]. Charm can be an important Greek to measure/monitor when delta-hedging a position over the weekend. Charm is a second-order derivative of the option value, once to price and once to the passage of time. It is also the derivative of theta with respect to the price of the underlying

Practical use

The mathematical result of the formula for charm is expressed in delta/year. It is often useful to divide this by the number of days per year to arrive at the delta decay per day.

This use is fairly accurate when the time to option expiration is large. When an option nears expiration, charm itself may change quickly, rendering full day estimates inaccurate.

Color

Color, or gamma decay (or DgammaDtime) measures the rate of change of gamma over the passage of time. Color is a third-order derivative of the option value, twice to underlying asset price and once to time.

Color can be important to monitor when maintaining a gamma-hedged portfolio. It can help the trader anticipate the effectiveness of the hedge as time passes.

Practical use

The mathematical result is expressed in gamma/year. It is often useful to divide this by the number of days per year to arrive at the change in gamma per day. This use is fairly accurate when time to expiration is large. When an option nears expiration, color itself may change quickly, rendering full day estimates inaccurate.

DvegaDtime

DvegaDtime, measures the rate of change of vega with respect to the passage of time. DvegaDtime is the second derivative of the value function; once to volatility and once to time.

Practical use

It is common practice to divide the mathematical result of DvegaDtime by 100 times the number of days per year to reduce the value to the percentage change in vega per one day.

There are other 2nd and 3rd order greeks. Today’s discussion is untended to introduce you to the fact that the greeks are all sensitive to the passage of time. And as with the first order greeks with which we are familiar, an approaching expiration date can produce sharp changes in their values.

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Adjusting with the Greeks

Mark,

I have been spending a great deal of time lately looking into making adjustments and all the various methods people use as part of developing my overall plan. I understand and subscribe to your idea that first and foremost you MUST want to own the adjusted position as a new position not just to save yourself from a "loss".

I have gone back and read some of your old posts about the three stages of adjusting and about your kite strategies. I am wondering if now would be a good time to post a refresher and maybe some new examples of the various ways one could consider adjusting positions and how to focus on Greeks when making different adjustments.

Thanks again for the great Blog and book. 

Scott

 Thanks for the suggestion.

My business is doing my best to help others learn about options – especially those in the earlier stages of their learning or trading careers.

Option trading is not mathematics. It is not an exact science. One problem I face is that when I express an opinion, some readers accept that as THE TRUTH. While that may be flattering, it's not my purpose. I believe in offering ideas that I'd like readers to consider. Obviously I believe each idea is sound, and is a reasonable alternative for the given situation.

When making such comments, I never know my audience on a personal level. Some readers are more sophisticated and can tackle more complicated ideas. Others are in position to seek higher gains and are willing to take greater risk to achieve their goals. Still others are very conservative traders who abhor risk.

The point is that it's difficult to give general advice that is appropriate for everyone. With that in mind, I'll tackle Scott's request.

Focusing on Greeks

is an intelligent method for reducing/eliminating specific risk. Good idea. The one aspect of option trading that separates it from all other forms of investing is that it allows specific risks to be measured.; You can measure delta (ok, so can any stockholder), but you also have the ability to measure the rate at which delta changes (gamma). You can determine the effect of time passage on the value of your positions, etc.

It's not so much a matter of focusing on the greeks and making specific trades related to the greeks that's important. Scott, if you look at your vega (or any greek) and let’s say you find that you are short 600 vega and that a 5-point jump in implied volatility will theoretically (the greeks provide an estimate of how the option prices will change; they do not provide a guarantee) make your position lose $3,000.

You can decide:

a) That's ok. The position can stand that much swing or perhaps, ouch. If the former describes how you feel, no vega adjustment is needed. If the latter holds true, then you want to buy some vega. It's not complicated. You could cover some short options, or perhaps buy a new positive vega spread.

b) Such a move is likely, so if 'ouch' is how you feel, you should take some risk-reducing action.  Or, you may feel that although it would hurt, it's so unlikely that you won't adjust.

You measure risk; then decide whether you want to take that risk or reduce it.  That's how to use the greeks.  It's not more complicated than that. When you have a good handle on risk, you are in position to take appropriate action.

Kites are too complicated for a review. At least not right now. I never finished all I had to say about them – because so much detail is needed.

I will say this about kite spreads. Any time you can own a naked long option at a cost that you deem acceptable, it does take a lot of risk out of a major market move.  But, it's not for everyone.

Examples

My basic premise on adjusting is that any one trade can illustrate what's possible. Almost any trade that reduces risk is helpful. For iron condor traders, that means reducing delta exposure, and perhaps reducing negative gamma and vega as well.

Examples are just that. There are always alternatives. Your individual needs and comfort zone boundaries often define how to adjust.

Let's say you traded 10-lots of a credit spread (or a whole iron condor) and the call portion is in trouble. With stock trading near 200, 15 points higher than when you opened the trade, you are short a 210/220 call spread that expires in 45 days.

If we take this as the given situation, some traders will object that they would never own this position unadjusted. They would have done something earlier, or say that 10-lots is too many (or too few). Others would say 'what's the problem?' The fact that such positions can be looked at as very risky by some while getting no more than a shrug of the shoulders by others already tells us that any 'examples' may be considered as unrealistic by the majority.

If adjusting a credit spread, iron condor, butterfly – any limited loss trade that has changed the position into one you are no longer willing to own, something must be done. The two obvious choices are to close or reduce. However, if you see something that turns the position into something desirable, then go for it. I don't know how to provide a list of possibilities that may appeal to any trader or group of traders.

A trader could buy calls or puts, buy debit spreads for delta, sell credit spreads for delta – but get even shorter gamma and vega. He/she could own calendars that widen where risk is now greatest. There is truly a large list of potential trades to help any position – depending on how you want to 'help' it. I use a limited number of adjustment trades in my repertoire, but each of us is limited only by our imaginations.

918
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Iron Condors and the Greeks

Hello Mark.

1.  Last week I traded an iron condor on Apple (January and February expiration) at 350/360 on call side and 290/300 on put side.

Past Monday, the prices of all four options, January expiration, went up for no apparent reason!  My January positions started showing big losses.  February positions were fine for same company and same strike prices.  What happened?   

The implied volatility for January options increased.  You opened your positions when implied volatility was at its low point.  Because iron condors are positions with negative vega, they lose value when IV increases.  That's what happened to you.  If IV moves downward again, you will recover the losses quickly.  Otherwise, it's going to take the passage of time (without a concurrent stock move) to recover.

Today, both January and February iron condor went up in prices, and again I see big losses.  I thought time erosion and call spread would help me.  

There is more than one greek.  Each contributes to the value of an option independently of the others. 

Theta is your friend.  You earn a small amount each day.  However, that is being offset.  Gamma is the enemy.  If the stock moves too far, then you get short deltas quickly (on a rally) or get too long (on a decline). 

Vega is the culprit you right now.  Vega measures the dollars earned (or lost) every time the implied volatility moves higher or lower by one point.  Right now it is moving higher.

When the market falls and the put spread moves against you, the call spread will NOT decrease in value fast enough to compensate for the loss in the put spread.

It truly upsets me that you thought that selling a call spread for a smallish premium would ever be enough to completely offset the loss on the put side when the market declines.  Sure it helps, but never enough,  The IC strategy is not designed to have one winner to offset the loser.  It is designed to win when the market is not very volatile and doesn't move too far – as time passes. [And there is no need to wait until expiration to grab your profit]

 

Is it possible for me to calculate option prices, independently? 

Independently of what?  The market determines the prices.  The market determines whether you earn a profit or take a loss.  No you cannot calculate option PRICES independently.

What you can do is calculate a theoretical value for any option. You can make an estimate of where you think the options should be trading.  That calculation may give you the confidence to hold your trade, but it will be your opinion vs. the collected opinions of the rest of the world.

To make the calculations requires that you input an estimated future volatility for each option (that's all four of them) into an option calculator.  Not an easy task for anyone, let alone a rookie trader.  Estimating future volatility is very difficult.  Dare I say impossible for the vast majority?  It is better to allow the marketplace to generate the option values. Then you can make trades that you deem suitable.

You may not have planned it, but you decided it was a good idea to get short AAPL vega at the time you opening the iron condor position.

What happened to you and your trade is that you chose to own negative vega at a bad time.  Not much you can do about that now.


2. My broker, thinkorswim, does not charge commission if I buy back short options if they are worth 5 cents or less.  Is it a good idea to take this offer? 

Yes.  I approve of reducing risk whenever possible.  Paying 5 cents is cheap insurance.  If there is just one day to go prior to expiration, then that's different.  There is no urgency to pay the nickel at that time.  But I love to pay that price (and more) to exit. I am also happy to pay commissions to eliminate the risk.  Free commissions make it a no-brainer for me.

3.  How do I know where (in stock, equity or ETF) a pro like you invests in iron condor? 

You cannot know.  Nor should you care, except perhaps to see it as an example.

There is no 'best' premium to collect and there is no best strike price to sell.  Nor is there a best time to enter the trade – unless you are a strict adherent of technical analysis.

You (honestly, I am not making this up) want to own a position that makes you, comfortable.  If you try to guess which position makes someone else comfortable, how is that going to do you any good?  You would not know when that pro makes an adjustment or exits the trade.  You must find trades that please you.  Sure you can read about what I do, but there is no good reason for you to attempt to do the same. But think about this:  You have no idea whether I am struggling, doing ok, or making a ton.  Not am I going to tell you.  It is completely irrelevant.

4. [A later follow-up to the original e-mail conversation] I can see that options pricing is lot more complex than I imagined.  I thought that earlier I place trade for next month, I get better price.  But that is not true.

It is true as far as theta is concerned. However, there are other factors that influence the price of options.

Here is the bottom line for you:  You clearly jumped into trading a strategy with no clear understanding of how it works.  That's fine when trading in a paper-trading account, because that's one good place to learn all about the trades being made.  But when using real money it's just foolish to think you can trade now and learn later. 

I find it very sad that you are in this position.  What is your hurry?  You have the rest of your life to trade and now is the time for learning.

868

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As expiration nears, how does theta behave?

Mark,

I am currently on my second round reviewing the greeks, and this time I am going into more depth. As I am putting together my notes I found references that describe time decay for both OTM and ATM positions. To my surprise, the shape of the graphs is different.

The graph that we are all accustomed to seeing shows that time decay accelerates as expiration nears. Most of the theta decay occurs in the last 30 days in which theta is increasing as the remaining time value of the option is decreasing.

Time_value_of_an_option__standard

When it comes to OTM options, according to the authors, the shape changes significantly. In the last 30 days, decay decelerates and the majority of the decay occurs before the last 30 days. This is the graph of an OTM option and its time decay.

Time_value_OTM_options_

I have been looking at various option series for both stocks and ETFs and I have not been able to confirm this.

Question.

If the above statement is true, when trading iron condors, why wouldn't you pick a timeframe for opening the position near 60 days to expiration and probably closing ~30 days before expiration? This would allow the trader to capture a larger portion of the time decay – because OTM positions make up the iron condor.

JG

***

This is a very thoughtful question and illustrates why spending time trying to understand the things we are taught is such a good idea.  Thank you.

The general view regarding time decay is correct.  Theta accelerates as expiration approaches.  However, we must recognize that some siturations are different.  Let's say that a stock is trading near 79, there's a week left prior to expiration, and the option under consideration is the 80 call.  Surely that option has time value and with that comes time decay – and the option loses value every day.  Just as you anticipate.

However, consider the call option with a 50 strike.  Unless this stock trades with an extreme volatility, the call has already lost all time value (except for a component due to interest rates) and trades with a bid that is below parity. 

Or you can look at the corresponding put (which has the same theta) and see that it doesn't trade and the bid is zero. It has already lost every penny of it's time value.  Its theta is zero.

These are the situations to which your references are referring when stating that time decay decellerates into expiration.  When options move to zero delta and 100 delta, the time decays disappears prior to expiration.

Most traders who are talking about options and their time decay, are not interested in such options (there is nothing of interest for a trader to discuss).  Thus, options such s the 80 call mentioned above (and the corresponding 80 put) have time value, accelerating time decay and an increasing positive gamma.  These options decay according to your first, or 'standard' graph.

FOTM options

There is more to the rate of time decay than the time remaining.  When options are far OTM or deep ITM, things are just different.  Once you understand that situation (as I'm certain you do now), the theta problem goes away. Once an option has only a small time premium remaining, it cannot keep losing value at the same rate – or else it would become worth less than zero.

Iron Condors

Time decay is what makes trading iron condors profitable. Sure it may be good to own the position when time decay is most rapid, but that is not the 60 to 30-day iron condors that you envision.  That would work only when the calls and puts are both quite far OTM.  That means a tiny premium to start the trade.  That's a non-starter for me.

In the real world of condor trading, most options are not that far OTM and have enough time premium to belong in the standard decay group.  When markets behave for premium sellers, the last 30 days are the periods with the most rapid time decay.  For most iron condor traders, that is the ideal situation. However, that's also the period of highest risk – due to negative gamma.  For me, collecting the fastest time decay is not as important as owning a less risky trade.

863

Liberty

Peace on Earth.  Liberty for all.  Best wishes for 2011

 

 

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Expiration Surprises to Avoid

This post was first published on Nov 16, 2010 at InvestorPlace.

InvestorPlace

Unless buying or selling options with a distant expiration date (LEAPS), each trader understands that the value of an option portfolio becomes increasingly volatile as the time to expiration decreases. I is important to be aware of specific situations that may crush (or expand) the value of your positions.

Here are six situations that should be of special concern when expiration day draws nigh.

1) Position Size

When trading options, the most effective method for controlling risk is paying attention to position size (number of options or spreads bought/sold). Smaller size translates into less profit and less reward. However, successful traders understand: minimizing losses is the key to success.

When expiration approaches, an option's value can change dramatically. The effect of time is far less on longer-term options.

Gamma measures the rate at which an option's delta changes. When gamma is high – and it increases as expiration approaches – delta can move from near zero (OTM option) to almost 100 (ITM option) quickly.

Option owners can earn a bunch of money in a hurry, and option shorts can get hammered. However, those short-lived options often become worthless. These are the conflicting dreams of option sellers and buyers.

The point is that having a position in ATM (or not far OTM) options is treacherous, and reducing the size of your position is a healthy and simple method for reducing risk.

Consider reducing position size when playing the higher risk/higher reward game of trading near expiration.

2) Margin Calls

Receiving an unexpected margin call is one of those unpleasant experiences that traders must avoid. At best, margin calls are inconvenient. Most margin calls result in a monetary loss, even if it's only from extra commissions. Think of it as punishment for not being prepared

When you hold any ITM short option position, there is the possibility of being assigned (and converting an option position to stock) an exercise notice. Early exercise is unlikely unless the option is deep ITM. However, you already know that any option that finishes ITM is subject to automatic exercise.

Exiting the trade prior to expiration makes it likely (there is still the chance of being assigned before you exit) that you can avoid the margin call.

Most put sellers (conservatively) sell puts only when cash secured. That means: cash to buy shares is already in the account. When cash is available, there is no margin call.

Those who write call options are subject to the same assignment risk. If the trader is covered, there is no problem. Upon assignment, the shares already owned are sold to honor the option seller's obligations.

When you receive a margin call, many brokers (no warning) sell enough securities (to generate cash) to meet that call. Other brokers automatically repurchase your short options (with no advance warning) before expiration arrives.

Bottom line: When you cannot meet the margin requirement, do not hold a position that is subject to early exercise. And never hold that position through expiration (when assignment is guaranteed). Find a way to exit the trade to avoid possible margin calls. For clarity: If margin is not a problem, none of this applies to you.

3) Increased Volatility

Pay attention to volatility – both volatility of the underlying stock or index as well as the implied volatility of the options themselves.

For option owners volatility is your friend. The fact that stocks are more volatile is enough to raise implied volatility, and that in turn increases the value of your options – sometimes by more than its daily time decay.

If you get lucky twice, and the volatile market moves your way, the option's price may increase many-fold. That's nirvana for option owners.

However, if you are looking at increased market volatility from the perspective of an option seller, volatility translates into fear. Whether a trader has naked short options (essentially unlimited risk) or short spreads (limited loss potential), he/she must recognize that the market (the underlying asset) can undergo a large, rapid price change.

Options that seemed safely out of the money and a 'sure thing' to expire worthless are suddenly in the money and trading at hundreds (or thousands) of dollars apiece. When an index moves 5% in one day (as it did frequently during late 2008), SPX options that were 40 points OTM in the morning were 10 points ITM by day's end. When that happens with an increase in implied volatility, losses (and gains) can be staggering.

There is good reason for the shorts to be afraid. One good risk management technique is to buy back those shorts – whenever you get a chance to do so at a low price. Remaining short, with the hope of collecting every last penny of premium, is a high risk game.

4) Reward vs. Risk

Expiration plays come with higher risk and higher reward. That's the nature of the game. In return for paying a relatively low price for an option, buyers have but a short time for the market to do its magic. Otherwise the option disappears into oblivion.

Most new traders believe they are locked into the trade once it has been made. Not true. You should consider selling those options any time that you no longer believe they can make money.

Don't sell them for a tiny premium, such as $0.05. For that price, take your chances.  But when real cash is at stake, perhaps when the option is priced near $1, then it's a difficult choice: hold vs. sell.  Make a reasoned decision.

Although it seems to be an obvious warning, when buying options near expiration day, please be aware of what must occur to earn a profit. Then consider the likelihood of that happening.

The same warning applies to option sellers. Time may be short, but when the unlikely occurs, the loss can wipe out years of profits. When there's just too little premium, cover the short position and leave the last bit of cash on the table. 

5) Option Greeks – Delta and Gamma

The greeks are used to measure risk. Once measured, it is up to the trader to decide whether risk is acceptable or must be reduced. It's important to understand the greeks of your position and how they change when the underlying moves. It's not necessary to spend hours studying the data. Use the greeks to get a look at the big picture and decide whether your position is ok as is, should be adjusted, or closed.

As has already been mentioned, delta and gamma change more rapidly near expiration (if the option is anywhere near the money). Stay alert to these changes.

6) News Events

When news is released, the underlying stock often undergoes a substantial change in price. If you have a position, or are considering opening a new position, be certain that you know whether news is pending. Such news is most often a quarterly earnings report.

If you are a risk avoider, don't hold short options with negative gamma in the face of earnings releases.

Summary: Expiration is an exciting time for traders who are either long or short options. If you want to play in that arena, understand what you are doing. If you are a more conservative trader, it's easy to exit all trades before expiration draws too near.

837

The November 2010 issue of Expiring Monthly will be availale Monday, Nov 22.  This month's issue focuses on commodity options.

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Diagonal Backspreads

Hi Mark,

I have a question on ratio diagonal spreads that I was hoping you could answer for me.

The spread is as follows: Sell 1 ITM Option, Buy 2 OTM Options where the IV of the front month option is higher than the IV of the back month options (e.g. Sell 1 ITM Nov Call, Buy 2 OTM Dec Calls).

I noticed that the position will lose money if the IV of the Dec options (the ones I am buying) declines. What type of adjustments can be made to this position if the IV of the long options starts to decline?

Thanks

D

***

The backspread is one strategy that I seldom discuss, primarily because it's not easy for individual investors to manage.

The diagonal backspread is a separate category and is worthy of a discussion. 

By definition, the backspread is an option position in which the trader owns more options than have been sold.  Thus, your 2:1 spread qualifies as a backspread.


Vega Risk

When owning options that expire later than the options sold, one unchangeable characteristic of the position is long vega.  Thus, the P/L picture is significantly affected by changes in the implied volatility (IV) of the options – between the time the position is opened and closing time [And that's true whether you exit voluntarily or hold through expiration].

The simplest method to guard against an IV decline is to sell vega.  And the simplest method for doing that destroys the very reason you opened the trade in the first place.  That method is to change the diagonal backspread into a 'regular' backspread.  For example:

a) Sell two Dec/Nov OTM calendar spreads.

This leaves you with the Nov back spread:
Long two Nov OTM; short one Nov ITM
It is not likely that you want to own this position

b) Sell one ITM calendar spread

This leaves you with the Dec back spread
Short one Dec ITM and long two Dec OTM

This idea is unsuitable.  Traders who use diagonal back spreads have a very different market outlook (expiration to arrive with the near term option's strike price being near the underlying price) than those who own  same-month backspreads (hoping for a very big move – so big that the ITM option is very far away from the price of the underlying).

It's nice when the simple method is viable, but in this case it is not.

A more complex solution is to add new positions with negative vega to your portfolio.  However, this requires trading several positions simultaneously, and not every trader wants to do that.

 

Suggestion

In my opinion, no single strategy is good enough to use all the time.  We must pick and choose our spots.  When IV, as measured by VIX, or better yet, the IV of your specific underlying, is relatively high – and you have no reason to anticipate that it will move higher – that is not a good time for owning positions that are vega rich.

I get it.  You still want to make the play that pays off when expiration finds the stock trading near the strike of your ITM short.  If you have a very strong predictive ability, and if you want to make that play, there are alternative strategies that have less vega risk.  (Butterfly for example).

However, if you predict market direction and future prices, then you should be willing to predict the IV direction as well.  There's no need to get it exactly right.  But, if you believe it's not going higher, I would avoid the diagonal backspread.  That spread is most appropriate when you have some reason to anticipate that IV will not be declining over the next few weeks.

I agree that this is something difficult to predict, but the diagonal backspread comes with vega risk.  You must deal with it or only accept that risk only when willing to do so.

If you insist on using this strategy because you had good results, consider trading smaller size when not confident about future IV direction, and larger size when confident it will incease. 

Another possibility is to divide your trade into two parts.  One is to use your diagonal, but in addition, perhaps you can sell a credit spread with strike prices that suit your prognostication.  That credit spread comes with negative vega.  It won't have as much vega as your diagonal backspread, but it is a hedge in that it partially offsets vega risk.

The bottom line is that it is easy to hedge delta risk, but vega is another matter.  The hedge is to sell vega, and that is difficult when owning diagonal backspreads.

805

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