I am relatively new to this forum and realize that most here believe that trading short vol. is the most reliable way to profit in options. I think that trading short vol. requires far more skill than most traders have (or even realize they need). I am a floor trader at the CME. Our contract went up 50 points this morning (75 point limit). Tics have a $20 value so a fifty point rally is worth $1,000 per car. I would like to share an object lesson on how difficult it can be to contain the beast. Then I would like to ask for some help. I spent the better part of this afternoon working with a colleague that has been a moderately successful trader. He came in short vol. and short 29 cars. His gamma started at -.57 and was -.89 fifty points higher. We had a strong rally and at settlement he was short about 59 cars. He was able to buy some expensive calls - I had 'em and sold them to him and sell some put packs. Buy and large he missed most of the move and lost about $50,000 in price action. Vol went up .5 in one month and 1% the nine other months he trades. The only months he is long vol. are Nov and Dec. This helped him a lot. Still he lost just over $13, 000 in Vega. On the upside he will be pulling in $1,224 in theta tomorrow. Of course, he faces they same problem tomorrow he had today. He is still short a lot of futures and is paying really high prices to get out of his options. Fortunately, he is trading under our "1-month rule" so this loss will not take him out of the game. But I would like to pose a question to you folks. 1) How would you recommend he exit this situation? Keep in mind, we can test these solutions against real markets. 2) How would you trade around a situation like this? incidentally, I recommended he flatten out his delta on the open and buy every call or put within 2 points of settlement vol until he is flat gamma. This will probably cost him another $20,000 and he is not to keen on this idea. I am hoping you can come up with something more palatable.
OK, first I'll say I love this kind of real life trading drama, but it's hard to offer useful advice without knowing what the tradeable is, what your friend's strategy is and how well he is capitalized. That said, obviously your advice was sound if he's worried about blowing up. Your first loss is your best loss.
The Black Swan Swims..........the Hawks and Vultures prepare to Feast. (1) Liquidate, don't pontificate. It would be interesting to know what percentage loss your "colleague" experienced in his account today. If it was more than 10%, all the more reason to get the garbage off the statement and start fresh. Otherwise, those open positions become a psychological burden and a constraint to clear-headed trading. (2) It should also quash the misguided notion that being "short premium" is a reliable way to trade options. It's a reliable way to earn smaller profits and expose yourself to larger losses. (3) Losing "big money" on the delta, gamma & vega AND earning "small money" on the theta is nothing to take comfort in. (4) Try to keep your positions "concentrated" instead of being all over the place with puts, calls, tons of different strikes and tons of different trading months.
None of the following should be considered advice, it is for the sake of educational discussion. I am not sure how useful my commentary will be given that I know none of the details specific to his situation. If he can afford to carry the trade, and if he sold the vols at a premium to stat vols, then he can delta hedge at 1/2/3 daily sigmas until theta catches up, implied volatility drops, or expiration. The profit or loss in that case is path-dependent, but independent of implied volatility if carried to expiry. The only way to hedge -gamma is with +gamma. If he chooses to carry the trade, he might consider buying gammas at 2-5 sigma in the nearest or most affordable deferred until the tails are hedged. If he cannot afford to carry the trade, or cannot afford the risk, he should get flat as soon as possible.
Very many traders have "blown up" with long gamma, short gamma does not equate to bankruptcy. Presumably he is making markets if he is a floor trader. How exactly would you suggest that he keep his positions from "being all over the place" given that he is making markets?
The trade is the Dairy options at the CME. A fairly illiquid futures market where volatility isn't usually a very big issue. We kind of drift back and fourth - moving 10 points up or down a day. This is not a tremendous loss for him (about 8%) - though it is the largest loss he has yet sustained. So he is not in the position where he is going to blow out. Of course, that could change very quickly if this continues for very long.
I agree that short vol. is not inherently bad. Rather, that if you are not on top of it when the market turns, it chews up your position rather quickly. Positions do get extremely difficult to manage on the floor - at least during the day. This is only because so much is going on right then. In the evening when you are inputting your position, you do realize where you are (in your Greeks), and you definitely can adjust the next day. As an aside, a few months ago I wrote that low delta options were under-valued because of the huge risk the seller was taking. I got flamed like mad. (That is also where I heard of the Black Swan for the first time).
I agree with much of what you say here (we it "eating like a bird and crapping like an elephant"). With regard to keeping a position concentrated - that is a rather difficult thing for someone to do on the floor. It is fairly straight-forward for someone to maintain both a delta and gamma neutral position if they are careful. But there is virtually no way for a floor trader to be anything but long and short both puts and calls over 10 strikes per contract. And we actively trade 12 contracts at a time.