Gamma, Vega and Risk Management

When trading options, holding positions with too much gamma – positive or negative – can be dangerous. It's necessary to avoid getting hurt by the two most destructive emotions for traders: fear and greed.

On Monday, Jun 28, 2010 the markets fell hard.  That 1040 SPX price level – that many believe is a vital support area – was tested.  Option prices rose sharply as is seen in the performance of VIX and RVX.

Tuesday (as I write this) the markets are slightly higher and option prices are once more coming down to earth.  I had better rephrase that.  Option prices and implied volatility are decreasing, giving up a significant portion of yesterday's gains.  In my opinion, prices are still high.  ADDENDUM: By the end of the day, the markets closed lower.  SPX broke down by trading below 1030.

When IV moves sharply higher, the trader who is not vega neutral, and that includes most of us, must demonstrate the ability to handle and manage risk.  If you are a clear thinker and make good trading decisions, your portfolio is probably in good shape.  The same can be said for most traders who prepared a trading plan in advance.  That plan is designed to save any trader (and especially the inexperienced) from panicking in a stressful situation.

Positive gamma and vega

As the markets get more volatile, and especially as markets decline, traders who own positive gamma and positive vega are well positioned to profit.  Nevertheless, that trader cannot afford to idly watch the markets as the days pass and theta takes its toll. 

Positive gamma is a delight in that it allows the trader to pick the time and place for making an adjustment.  This adjustment locks in profits and can include the sale of some options to reduce both gamma and vega, or it can be made in the form of shares of the underlying (stock or futures contracts).  It's tempting to hold the position, but a minor reversal, such as seen Tuesday morning threatens much of the profits.  Greed makes the trader hold out for larger gains.  Fear makes the trader panic and sell (what is probably) an inappropriate portion of the position.

However, a well-thought out plan, or sound risk management, allows the trader to reduce risk by moving closer to neutral in gamma, vega, and delta.  Ignoring greed, the successful trader adjusts the position – retaining some vega and gamma.

Negative gamma and vega

Iron condor traders seldom find themselves in the positive gamma/vega boat.  The only exception occurs when extra options are owned as insurance, and these extra options are in play (not too far away from being ATM).

Thus, they (we) may be floundering when the positive gamma group is sailing along smoothly in those choppy waters.

If your positions have too much negative gamma, if your short options are not too far OTM, then it's time (or past time for many conservative traders) to adjust the position.  Panicking in a sudden meltdown is unlike to produce good results.  However, ignoring problems, hoping they will disappear, represents a different type of panic decision – being too afraid to act.

If you have a trade plan in place, it's probably right to take the action as prescribed in the plan.  Lacking a plan, it's not too late to create one now.  If you are capable of making sound decisions as losses mount, then good for you.  Take advantage of that skill by taking sound steps to protect your assets.  Be aware of potential loss, your pain threshold and comfort zone boundaries.

If you lock in a loss and the market reverses, so be it.  Your goal is to pay attention to rule #1: Don't go broke.

If you are not yet in trouble on this decline, you have the luxury to plan ahead.  I'm planning to sell extra vega by doing a ratio roll down* for some RUT Aug and/or September put spreads.

* Close current short put spread and sell a larger quantity – perhaps 3 for every 2 bought – of farther OTM put spreads.  I prefer to move the strike of the short option by at least 3 strikes.  Collect a small cash credit for the trade.  I only do this when my portfolio is not already at its maximum size.  Make no mistake about this trade: it does increase ultimate risk.  it looks good because the probability of the large loss is reduced.

Example buy two 560/550 put spreads and sell three 500/510 (or perhaps 510/520) put spreads.


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6 Responses to Gamma, Vega and Risk Management

  1. Fran 07/01/2010 at 11:29 AM #

    Hi Mark,
    about your ratio roll, do not you think that you are proposing a kind of martingale increasing the size of the position by the losing side?
    I thik when the market attacks a negative gamma position it is best to reduce your exposure on that leg, gradually if you prefer and wait until conditions improve to increase your risk again.
    Surely you are agree with me, but it seemed interesting to comment.
    Regards and good trading.

  2. Mark Wolfinger 07/01/2010 at 11:49 AM #

    Hi Fran,
    Yes, I have a fear that this type of trade may be made by the wrong traders. It sounds very attractive. Those who ignore risk may get into trouble.
    However, I like this trade when IV is elevated AND when ultimate portfolio risk remains at an acceptable level.
    Whenever I mention a size increase I always stipulate that this is appropriate ONLY when current positions are less than the usual maximum. If a trader has 20 iron condors every month, and has 20 now, then increasing size is not the way to go.
    However, if for some reason (perhaps size has already been reduce in an early adjustment) that trader currently helds a dozen iron condors, then I believe it is appropriate to increase size to 18 – if the new position meets all criteria for new positions required by the trader.
    Thanks for the comment, and I very much agree with you. That’s why I prefer to adjust in stages, reducing size – beginning when the trade produces thesmallest amount of discomfort.

  3. Henry Tzuo 07/05/2010 at 6:04 AM #

    Hi Mark:
    Good morning and just curious — By the “Flash Crash” on May, 6th, 2010, By what you know personally, is it still possible that a bull put spread (sell high ex and buy low ex)makes a trader get a “flash bankruptcy”??? Although at the end of that day, the market was down only 3.6%. How should people choose the ex price diff to avoid a “flash bankruptcy” ???
    Is “total position worst case scenario” the only way???
    Henry Tzuo

  4. Mark Wolfinger 07/05/2010 at 9:36 AM #

    I reposted the entire reply as a separate blog post, Monday Jul 5, 2010. “Mark to the market nightmare”

  5. Mike 08/02/2012 at 10:58 PM #

    Hey Mark

    Being a newbie option trader I appreciate the information you give away freely on your blog. I’m more than likely going to have to join your club as I’d definitely like to spread my risk profile in my investment portfolio. What you mentioned in this post about having a plan and sticking to it is so true and something I surely have to abide by more. Thanks again!

    • Mark D Wolfinger 08/03/2012 at 7:17 AM #


      I’d be happy to work with you