Hello, I've come across option traders who try to capture theta premium with guidelines such as theta/vega ratio of 1:1 (for a net short vega position) and theta/gamma ratios above 0.2 for overall portfolio greeks primiarily as a mechanism to manage risk and income goals. Some of this makes sense, theta/vega ratio ensures that a certain level of premium is captured given a set of volatility especially when IV cannot be fully assessed across several months. Theta/Gamma to control swings for a delta neutral stragey. Does anybody have guidelines such as these? I'd like to know. In case people are interested, I self-manage a portfolio margin account primarily trading volatility on indices and on futures options. Approach is to stay delta neutral, short gamma, capture a certain positive theta as porfolio % and stay slightly negative vega. Thanks!
Collecting theta is a fine way of growing a portfolio - the challenge is how to deal with the gamma and vega risk when market volatility suddenly rises. This has been discussed ad nauseum in this forum and I encourage you to search. Short answer: Develop a volatility forecasting model, backtest the perceived "edge", optimize parameters such as position sizing, and become both a short and long volatility manager. Good luck to any and all.
Thanks Niten, As a traditional marketmaker, we are using LiveVolX to aid with our volatility forecasting and trade with their skew curves. Also, we try to stay net long with options (market value-wise) and hence slightly positive vega. However, my question is if anybody on this forum with 7 to 8+ figure accounts have done trading looking at theta/vega or theta/gamma ratios, specifically? This appears to be a popular method for prop trading firms where traders aren't sure what is undervalued or overvalued premium. Also, I've talked to hedge funds who watch these ratio for their greek instrument cluster.
There's no such thing as a fixed guideline re theta/gamma/vega ratios. They are all depending on the product you trade, mainly the value of the underlying... When you trade a lower priced stock or index, the theta/gamma ratio might be 1:100 and a higher priced stock it might be 1:0.50... but they have the same risk...
Jack, How can they be not normalized to each other? We are dealing with rates of change. I have posed this question to some very knowledgable operators. I get the 10 sec of silence that means: "You are over thinking it, man." My conclusion was DTE was more than sufficient as the cutoff parameter though blunt. Thanks.
To the OP: I would like to make an analogy to fixed income management. A bond manager lessens his convexity risk by shortening duration. But nowhere in their numbers do they use anything that resembles a yield to convexity parameter. It may be a case of "over thinking it". But, I do like the inquiry and think this should be discussed further.
You can normalize it... say index it to 100... Theta stays the same since it's a dollar amount... basically what you get after 24 hrs. Gamma(Ni) is (100/spot)^2 x stock gamma Vega also stays the same, since it's a dollar amount on 1 point vol move. But I meant to say that even the starting point isn't as clear cut. I doubt the OP has heard of net-indexing the gamma etc. Beyond that, the relationships change over time, with IV changes, etc... Theta/vega relationship doesn't say anything to me, since it completely depends on DTE... Longer dated has more vega, but less theta... and less gamma. Also the IV changes theta and gamma... but not the vega.... at least, not the ATM vega... but it does change OTM vega... So it's just not that easy/basic as aiming for a certain ratio...
atticus once recommended keeping theta under 1% per day as a sort of maximum risk tolerance. https://www.elitetrader.com/et/posts/3479875/
That's a BS number... theta is not a risk metric on it's own. If he means he's comfortable to just make 1% of netliq on theta... okay... but where's the theta coming from? 3 DTE? 30 DTE? That's the big question you should be looking at. A 1% theta of netliq 30 days out is way more risky than 3 days out.... You need about 3x the position 30 days out to get the same portfolio theta as 3 DTE
The guy has infinitely more experience than I do so I won't claim to speak for him, but I think the argument is that it's a good consolidated risk measure in the sense that you collect theta for selling gamma risk. It might take 3x the position to achieve the same theta farther out, but then it takes 3x the position to achieve the same gamma risk too. Raw position size is clearly not the only measure of risk...