Tag Archives | volatility

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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Lessons of a Lifetime: My 33 Years as an Option Trader;  $10


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VIX Graphs May 21, 2010

There is no doubt that volatility has returned to the markets, and the graph below doesn't tell the whole story.  Intraday volatility has shown some remarkable swings.

Excluding 1987 and 2008, this week VIX visited a level seldom seen (>45).  There is definitely a lot of fear and investors are grabbing options to protect themselves – or to speculate on a big market move.  It's amazing to me that people seem to use option strategies to protect their portfolios only when everyone wants to buy options.  They choose to own insurance when that insurance is costly.


An expiration story

Last Thursday afternoon, the day before settlement prices were calculated, Jason posed this question:

I'm short the May 620/630 RUT put spread. Currently trading at 651. Settlement is
tomorrow. Settlement always scares me since getting sideswiped in March.
Could it settle more than 25 points down from close?

I told him that yes, it could, and suggested that he exit the trade.  In fact, after he wrote, the market declined further and RUT closed for the day at 640.

I held my 620/30's open. (Never again). Got busy, came home to
closing of 640. Lesson learned. Sleepless night ensued.
RUT settlement (ticker: RLS) finally came out at 629.95. Bullet avoided.

Restless night coupled with having to wait until after the market closed for the day (Friday) to see the results.  Not worth it.  And Jason agrees – I hope that 'never again' quote becomes reality.



"Your chapter on Equivalent Positions was the clearest explanation that I have ever read.  I
learned a great deal – and it made sense!  Thank you for making the
effort to put out such a fine book." DS

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the Magic of Higher Call Prices for Falling Stocks


I still consider myself a rookie so I have what may be a
"rookie" type question.

I am selling covered calls and I am seeing that
the option/stock price relationship has NOT been maintained in a way
that I would expect. The AAPL stock price is lower, but the option price is still higher than when I sold it. (There
was a big run up in price before falling back to today's level.) There
hasn't been much passage in time as I bought/sold in April.

What would cause this? (I have to admit I don't understand the Greeks




Hi Larry,

This is a common problem and easily explained.  Once you get it, you will remember.  But, until you read or hear that explanation it can be a true puzzle.

An option's price is based on several factors, such as the stock price, strike price, time remaining.  But the crucial factor that determines how much the price of an option changes in the marketplace is volatility.  Each of these factors is plugged into a computer, which calculates the value of an option based on one of several models.  One of those models may be familiar to you: Black-Scholes.

Simply stated, if market participants believe the market (or sometimes the specific stock) is going to be volatile from right this minute through expiration day, then the options are worth more.  Buyers bid higher prices and sellers demand a higher premium for the risk they are accepting.

Why do they bid more?  If you buy an option, you want to see the stock move higher (calls) or lower (puts).  The larger the anticipated move, the greater the profit potential.  That translates into higher bids for those options.  Similarly for sellers, big moves turn into larger losses, so they demand higher prices to offset some or all of that risk.

That expectation for increased volatility (compared with the expectation when you wrote or sold that call) is the reason the option prices is higher.  And that option price can go higher still.  Or it can drop like a rock.  All depending on that expected volatility.

To keep it simple, a volatility estimate must be plugged into the Black-Scholes model to generate a theoretical value for the option.  the higher the volatility, he higher the option price.  If you have never played with an option calculator, you should do so.  It can open your eyes.

But that's the reason your call is priced higher today, even though the stock is lower and some time has passed.

Regarding the Greeks.  Do not be afraid of them.  the Greeks serve one purpose:  To measure risk of holding a specific position.  When the investor finds that risk to be unacceptable, action is taken.  You may exit or adjust the trade.  The point is that the Greeks give you a good estimate of how much you may make or lose if such and such market event occurs. 



Buy Now

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