Neutralizing Risk When Trading Options II

Part I

If
an investor/trader owns an option position that has become too risky to
hold as is, it's common practice to adjust the delta.  If options are
purchased when making that adjustment, then positive gamma is added to the
portfolio, and that helps lessen the effects of another adverse move in
the price of the underlying.

But there's more to risk management than paying attention to delta and gamma.

Vega

Vega measures the sensitivity of the price of an option to a change in implied volatility.

As most option traders learned in the Fall of 2008, when implied volatility surges, the price of all options increases significantly.  Depending on the strategies you were using at that time, your positions were probably affected to a large degree by those very volatile market conditions.

If undergoing a similar experience is an unpleasant thought, and if you want to limit the effects that market volatility has on the value of your option portfolio, you can adjust the vega of your portfolio so that it becomes vega-neutral.

For example, trading any or all of these popular strategies gives an investor a portfolio that is short vega:

Writing covered calls
Selling naked puts
Iron condors
Sale of credit spreads
Sale of strangles and/or straddles

There are steps you can take to add positive vega to any portfolio – and you should be able to find one that gives you a position to want to own, rather than some mess you put together in an attempt to reduce vega (or any other) risk.

Calendar spreads have positive vega and can be added with strike prices that reinforce areas where risk of loss increases.

New diagonal or double diagonal spreads work nicely when combined with an iron condor portfolio.

When you buy puts and or calls, you gain vega and gamma at the expense of theta.  Depending on the options chosen, delta can be added or subtracted. 

This may seem trivial, but remember that an intelligent trader does not open a position and come back at expiration to see what happened.  Even positions that are not losing may my require a minor makeover if market conditions make your position move beyond your comfort zone boundaries.  Yes, even profitable positions can be adjusted. 

Theta

One
of the most attractive aspects of selling option premium is the idea
that – if nothing bad happens – the options you sold decrease in value
every day.  Theta is the Greek letter used to describe the theoretical
time decay of an option – as one day passes.

On the other hand,
positive theta is accompanied by negative gamma.  It's nice to own that
time decay, but it's important to be aware of the cost, in terms of
being exposed to a major market move.

If you have a directional
bias in the markets, as most traders do, then you may be tempted to buy
options, hoping for a huge profit from a correct prediction.  Owning
options is a risky proposition for many reasons – despite the fact that
losses are limited to the purchase price of the option.  Time is the
enemy for option buyers and the best method for reducing that risk to
to buy directional spreads, rather than single options.  That play
reduces potential profits, but it makes it much less risky to own
positions – simply because the position has much less negative theta.

Another
method for reducing theta risk is to sell a near-term options when you own a longer-term option. 
You hope for those near-term options decay rapidly and expire worthless.  However, if the move you anticipated occurs quickly, and is stronger than your estimate, all profits can be lost when the near-term option explodes in value.

It's easy to sell options to alleviate some negative theta risk, but doing so introduces a different risk.  It's generally safer to sell options that are farther OTM than your longs – and with the same expiration.  No need to take gamma risk when reducing theta risk.

Bottom line:  Options allow management of specific risks, and that makes them powerful tools for your trading arsenal.  When using options to reduce one risk, please be careful not to increase a different risk factor so that the position exits your area of comfort.

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