Long Vega Strategies

With '03 rapidly coming to a close, it might be a good time to start evaluating some new or refined strategies for the new year. I was thus hoping to start a discussion of some limited risk vega positive strategies that could exploit the across the board rock-bottom vols with the assumption that vol may rise in '04 (for those who think vol will stay low or go lower, that's fine, but this is not a discussion for you).

Let's see if we can limit this discussion to practical nuts and bolts tactical issues based on traders' real world experiences, such as the types of stocks/indices they've found these strategies to work best on, entry criteria, position management, etc. Also, while backspreads and long time spreads are my long vega strategies of choice, if people have had consistent success with long straddles or other vega pos strategies, please share.

Hopefully, as a result of this discussion, we can all improve our trading, expand our arsenals and bank some additional coin in the coming year.

HD

 

Good idea HD, and in line with what we've been discussing privately.

Long time spreads are well priced in this environment, long vega, short gamma -- so they've got a somewhat schizophrenic personality. While you'd like to see an increase in implied vols, that usually comes at the cost of increased spot volatility -- which is detrimental to the position.

If I have a point, it's simply that I wouldn't want to run time spreads as a sole-methodology, as an increase in vols in the broad market will likely result in gamma losses on the spreads, in many cases, losses greater than any gains due to the +ve.

Long time spreads are poorly suited for other short gamma positions in terms of greek exposure for the aforementioned reason -- the long vega is quickly rendered moot by it's short gamma attributes. It's an excellent alternative to a long fly when volatilties are low and flys are expensive -- correlates well when attempting to reduce the gamma/theta exposure of a long straddle/strangle position.

I'll only add that it's best to look for high-dollar underlying stocks with this strategy, ETFs and indexes are best suited to long time spreads.


Backspreads/wrangles are explosion strategies, long vega. The theta exposure depends on the credit(debit) received(paid) on the spread, and you can imagine that the theta exposure is minimal. Again, like the time spread, these aren't income methods, but spreads typically suited to mimimizing greek exposure. These have been discussed at length in this forum.


arb.

 

Well maybe it would be useful if we list some basic (and non-basic strategies) that are helpful for vega positive strategies. I guess the two most obvious plays are to either buy atm strangles / straddles or buy otm options (I kind've like the idea of buying leaps here and legging them into cheap or free spreads). Im sure there are other plays but Ill have to let someone more experienced talk about those. So In general I like the idea of buying otm leaps (prob. 2005 maybe even 2006 but I personally dont like to go out that far too often) and legging into the bull spread.

 

Thanks Arb. Your always insightful advice is most welcome.

Yes, I agree that long time spreads should not be one's sole strategy. However, for someone like myself who is typically short a lot of vega from index iron condors, and in light of the current low vol levels, they seem like a reasonable low risk non-directional way to hedge some of the negative portfolio vega. Plus, they fit with my overall approach, which is to be theta positive.

The recommendation to focus on high-priced stocks and ETF's for these is very interesting and precisely the type of practical advice I was hoping to elicit through this thread.

Thanks again.

HD

 

OK, I guess long vega has not been discussed that much on here lately. First off let me say that I agree with risk arb in that long time spreads are not a good way to be long vega because the spread is kind of a contradiction of sort. You want implied volatility to increase but you want statistical volatility to decrease. LOL. Try putting that spread on without going on prozac!

So I think the best way to go long vega is the good old fashion straddle/strangle. But having said that, let me make a few comments about this. A lot of people put these on and then lose a lot of money and then say to me, Mav, I don't get it, I bought really cheap vol and the vol ran up 30 pts and I still lost money, what gives? LOL.

So let me go over the what gives part. Remember that vega is a function of time, a lot of people forget this. What this means is that the further you go out in time the more vega you have and the shorter the time, the less vega you have. Also vega has a relationship to the strike price. At the strike the vega is the highest, as you move away from the price, vega decreases.

So let's try to understand why this is important. If you bought a ATM straddle 6 months out going long vol at lets say 30. Right now the spread carries very little theta and very little risk. However, ideally you would want vol to increase pretty soon. Let's say 3 months go by and vol is still not increasing. Now your vega has actually decreased substantially and your theta has increased substantially. On top of that if the stock has moved away from the strike, your vega is even less. another month goes by and suddenly vol explodes to the upside but guess what, almost all your vega is gone and you profit very little from it, instead you know have a ton of theta. So a lot of people put these spreads on and don't understand the relationship vega has to time and to price.

So how can we avoid this, well obviously by going further out. Also we might tend to want to hold these for short periods of time. So say you bought a jan 04 leap today. You might only want to give this spread till April or May to do something then roll out of it. But let me point out the problem with leaps. Price. Not the cost of them but remember what I said about the strike price. If you are buying leaps 12 months out surely the stock is not going to sit at the strike price for 12 months, you better hope not anyway. LOL. So if the stock makes a big move to the upside lets say, as you move away from the strike you start losing vega. So as time goes by you have two things now working against you, the price and time.

So what to do now? Well you have a couple of options. One is obviously to combine your vega play with a directional play i.e. taking a long straddle position in overpriced stocks that you think are going to tank. So not only are you long vega but you are also going to let your deltas accumulate on the short side. This will compensate for your move away from the strike price and the passage of time.

What else can you do? Buy more straddles. Say stock XYZ is at $50 today, you might buy another jan 04 leap next month when the stock is at 65 and you might buy a feb 06 leap when the stock is at 80. Now you have a wide range of prices to work with. So if the stock comes back down and trades between 50 and 80 you will always have vega exposure somewhere.

OK, I'll stop here. Any questions, feel free to post them.

 

My biggest question with straddles and strangles is how best to exit and enter them effectively. Where I dont trade straddles or strangles often they often appear to me to need a relatively large move in the underlying to expire profitably. So under the assumption that were buying straddles further out in time and that were not holding them till expiration. What rules or guidelines exist on when to exit. I know there is mathmatically methods for determine when to exit on calls and puts but do those or any other method apply to straddles, etc. Plus where straddles and its cousins start delta neutral they end up moving into direction play. Do you plan to hedge them or let them drift into directional plays and if so, what are the advantages over say my idea of buying otm leaps (other than the fact that Im guessing a direction to the move where straddles and friends arent guessing the direction).

 

Sorry, Mav, but, while I don't want to speak for RiskArb, I think you missed his point. I understood him to say that long time spreads are in fact a very good way to go long vega. He merely pointed out some of the issues to be aware of with the strategy. However, despite a prior thread, I'm not sure there's a "perfect option position", and thus there will be trade-offs with every strategy. Hence, one must select the approach that has the highest expected return given the specific market environment and one's particularized outlook.

So, with that said, let's get back on topic, shall we.

 

With the long time spreads, that is more of a theta play then a vega play. Why would you want to be long vega and short gamma. If the vega increases its because the gamma went against you. The problem with that spread is that you want the stock to stick at the strike price, that is where the maximum reward is. If it moves away from the strike you will realize a maximum loss, the increase in vega can only compensate for some of this loss not all of it.

It's going to be really hard, not impossible, but really hard for you to find plays that have vol going up while the stock is sitting still. I just think you are going to have to work really hard here to make this work and we all know that option trading is hard enough as it is.

Now I'm not saying long time spreads are bad trades, quite the contrary. They are very good spreads to sell premium safely. However if you want to just go long vega there are a thousand better ways to do it. Risk arb now this and so do I.

Now if you wanted to modify this spread and add a kicker you could do that. Lets say sell the jan 50 straddle and buy the jun 50 straddle and then buy the jun 55 strangle, then you have something a little better because now you have more vega in the back month and if you get a large move that hurts your short gamma you might be compensated by the extra vega now.

 

First of all, who ever said I didn't want to be short gamma? Not me. But if I didn't, I'd prefer a backspread over a long straddle any day. There's way too much theta exposure with a long straddle for my tastes.

But, if in fact, there are "a thousand better ways" to go long vega than with a long time spread, why don't you share with us a few workable ones besides the long straddle idea.

 

What about long vega before certain events like triple witching or earnings reports. I have noticed that volatility runs up before earnings and drops off after the release. Would buying an ITM straddle a week before the report be a decent long vega strategy if IV was near the lows or in the middle of the range?