Neutralizing Risk When Trading Options

Sophisticated option traders loathe risk.  The larger the positions they trade, the more important it is to manage a portfolio with as little risk as possible.  Thus, market makers (and the trading firms that employ them) use sophisticated trading algorithms that automatically raise bids for options that reduce current risk while simultaneously raising the asking price for options that would make matters worse.  By bidding higher than anyone else, the probability of buying needed options increases.

None of us trades like that.  Nor is it feasible to have a Greek-neutral portfolio.  We choose to be as neutral as necessary to remain within  our individual comfort zones.  The most common way for individual investors to be neutral is owning positions that begin life delta neutral.

I've devoted many blog pages to methods that can be used to adjust positions to reduce risk, including ideas such as closing (to end the misery) or rolling out of the current position, and the idea of adjusting in stages, instead of making an all-in-one adjustment.

Because the positions under discussion were almost always iron condors, these risk-reducing ideas focused on the major risk factors that are of concern when an iron condor has moved against you, and those are delta and gamma.  When delta risk is too high (the position is too long or too short – and another move in the wrong direction is costly.  When gamma is negative, that loss accelerates as the move continues.  Ignoring these risk factors is hazardous to your financial health.

The other commonly monitored Greeks (there are always more risk factors than can be considered if the trader wants to get more and more sophisticated) include theta and vega (sensitivity of an option's value to changes in time and implied volatility, respectively). 

Next time I'll take a look at theta and vega and consider some choices that are available when you decide to reduce (or increase) your exposure to these risk factors.

to be continued

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2 Responses to Neutralizing Risk When Trading Options

  1. DominiqueRoloff 04/26/2011 at 5:27 AM #

    This is a bit off topic but have any of you thought about successful options trading without having to predict the price movement?

    • Mark D Wolfinger 04/26/2011 at 8:09 AM #

      DR,

      All the time.
      I never predict direction.
      I take a market neutral stance. Yes, I understand that one can call that predicting direction: either no movement, or big movement.

      That’s ‘no direction’ for premium sellers and ‘either direction’ for back spreaders and straddle buyers.

      Trying to predict market directions using options is a very difficult game.

      Thanks

      There are other, more sophisticated methods that can bring significant returns.