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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.

730

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