Trading Options: Risk Management and Vega

Here's something I've said before:  It's easy to make money when using the recommended option strategies,
but the difficult part is keeping those profits.  Good risk
management allows you to hold onto your gains and thus, succeed
over the longer-term. 

It's important not to ignore the possibility that the unexpected can, and will occur.  [It happened so frequently in 2008 that it was no longer unexpected.]

Today's post is inspired by a post by Adam at Daily Options Report.  In turn, his post was inspired by Steve's post at Minyanville.  [Good advice is available when you know where to look.] 

They were discussing vega risk when trading options. 

From Steve:  "Vega is defined as the expected rate of change in an option's value for a one-unit change in implied volatility." 

For example, consider an iron condor position that is short 300 vega.  If implied volatility for each option moves higher by one point, the position should lose $300.  Other gains and/or losses due to delta, gamma, and theta go into the mix to determine the day's profit or loss.

Adam added: "As a trader, vega is truly the single most important variable in regards to options position management. And it's the least predictable. You know the daily decay of an option, or a position filled with options. You know how delta and gamma will behave. But vega? Anything
can happen."

Indeed anything can happen.  Changes in implied volatility may be smooth, and being long or short vega becomes unimportant.  But sudden, unexpected changes occur often enough that it's prudent to pay attention to your portfolio's total vega.  It was only a few months ago that implied volatility soared to levels not seen in more than 20 years (since October 1987, when it was much higher). 

Here's a 2-year graph of VIX, the CBOE Volatility Index. 

As an iron condor trader, my recommended method for adding positive vega to a portfolio is to purchase extra puts and calls.  However, I prefer buying less expensive, much less vega-rich short-term options.

Because risk management is so important, please accept this message as a reminder not to ignore vega risk.


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