Time to go vega positive?

Discussion in 'Options' started by Hello_Dollars, Nov 7, 2003.

  1. While I'm not inclined to try and catch a falling life, and while there's some merit to the "if it ain't broke don't fix it" approach, it seems the risk:reward of continuing to play the vega negative card may finally be suggesting a different tack. Hence, I'm contemplating establishing some diagonal spreads on the XEO as opposed to straight iron condors, which have worked so well for most of this year. Any thoughts from vol traders? Thanks.

  2. Maverick74



    One of the things option traders try to do is not look at volatility at an absolute level but on a relative level. Saying volatility is cheap or expensive can be very dangerous. What most market makers try to do is buy as much relatively cheap vol as they can and sell as much relatively expensive vol as they can. Note the use of the word relative because that is what it is.

    So while you may look at the vix right now and think it's cheap, which it is, why not look at cheap premium vs expensive premium. And keep your overall portfolio vega neutral. This would be my suggestion. I have seen a lot of big moves to the upside on vol lately. And big droppoffs. The goal here is to have a large enough portfolio so as not have aggregate delta risk, vega risk, theta risk and gamma risk. Try to keep your portfolio as flat as possible and within that portfolio you can lean deltas, have long vol, short vol, long gamma and short gamma.

    This is a much better way to make money then to just take a stab at vol because its too high or too low in the indexes. Most market makers make a very very good living doing just this. It's all about keeping balance in your portfolio and making the right adjustments. Hope this helps.
  3. Mav,

    Thanks a lot for the very cogent advice. I actually couldn't agree with you more. Indeed, I've been working on developing an overall trading strategy that hedges a core gamma/vega negative position that I've been trading for a while (iron condors on the XEO) with offsetting vega/gamma positive positions using select instruments and securities (as a quasi-dispersion approach). Hence, I agree that one needs to view risk in terms of an entire portfolio and all the Greeks and not just position by position.

    I guess I was prompted to pose the question because my iron condors are such a significant component of my trading strategy each month and because I've been listening to too many friends who trade options professionally on the Street who've been warning me for months that volatility couldn't possibly go lower, that it was primed to explode and that gamma negative was therefore doomed. Of course, they've been losing a lot of money this year with gamma and vega positive trades, which is an experience I've thus far been fortunate enough to avoid.

    Still, I recognize the risks and am taking steps to hedge it off.


  4. :


    Premiums most certainly cound go much lower in major indexes;
    putting on trades because ''vol couldnt possible go lower'' is an excellant way to lose money.

    However agree with your option pro friends about the most likely scenario is premium primed for upmove,maye be an explosion.

    Especially likely higher in tek , especially like every major index has been doing since March.:cool:
  5. As a novice option trader, I was operating under the notion that IV has a mean reversion property, so I too would be going vega positive, esp. since Ive been purchasing LEAPS primarily. Im not sure how wise this is but I would still bet IV has more room on the upside than the downside. One question for Mav though, you mentioned looking at vol. in a relative vs. an actual manor. Are you refering to Expiration / Strike skew of volatiliy? Sorry if the question is obvious as I have really only been trading less than a year. :)
  6. Maverick74


    Yes, IV is mean reversion but that is not saying much unfortunately. To understand volatility you have to understand how it lives and breathes. Also lets make a distinction here between IV on indexes and individual stocks. There is a big difference. For individual stocks IV does not necessarily correlate with stat viol. I had this argument with Don. It's a very common misnomer. I would almost go as far out to say that stat viol has very little correlation with implied viol. If implied viol was tied to stat viol let's say 100%, then implied viol would be very mean reversion and very easy to trade. However implied viol has a risk component added to it. Implied viol is actually in my opinion more of a risk meter per say.

    Let me give you an example. Say stock XYZ is trading at $50 a share. It has a stat viol of 35 and implied viol of 30. Let's also say that the implied viol is in the lowest 1/10th percentile of its implied viol range over the past year making the options look really cheap. Let's also say that stock XYZ is very strong in fact trading at it's 52 week high. It has been in a steady uptrend all year. Well the primary reason why viol is so low is because there is very little risk in this stock. It's very strong and it just keeps trending higher therefore the premium is pricing in very little risk. Say you were to buy these options because of how cheap they are and figuring that viol is mean reversion you decide to buy some long term options on XYZ. Let's also say you are buying straddles since you don't know or don't want to predict the direction of the stock. Well here is the problem you have. Even if the stat viol on XYZ increases the implied viol will more then likely continue to go lower. Why? Because as the stock goes higher the risk is less and less. Also there is a mathematical property at work here and that in simple terms, if the range of the stock stays the same as its rallying, the actual stat viol will drop as the price goes higher. So as long as this stock keeps making new highs and it could stay in an uptrend for years, then implied viol is not going anywhere.

    Also something else to add here that many good option traders forget about it, is the relationship vegan has to time. So let's say you buy options that are 6 months out to get a lot of long vegan. And you wait and wait and the stock just keeps going higher. Well, 5 months from now suddenly the stock is downgraded and it starts to come in. Well, you have a pretty bad situation here. Because, the implied viol may have come all the way in to 20 now from 35 so you already took a hit on that but now all your vegan is gone. Why? Because vegan decreases gradually with time. Now your position is ready to capitalize on vegan but you have no vegan left. Instead you have a lot of gamma and a lot of theta. So now your position will gain nothing from the increase in viol but your bleeding profusely with the high theta now. The only thing you can do to save yourself is to hold on to your neg deltas and let your gamma work for you. But then you run the risk of the stock snapping back up and killing you.

    BTW, the same scenario plays out on the downside just the reverse. As a stock is falling and the viol is really high, as long at the stock stays in the downtrend, the viol will keep ticking up. It might be statistically overpriced as hell but it's going higher. Again, the same math applies, if the range stays the same all the way down, the stat viol is going to expand every tick on the way down.

    So you can understand now why the vix keeps dropping. It's dropping because the mkt keeps going higher and higher and there appears to be less and less risk in the mkt. If the mkt stays in this uptrend for another year lets say, then the vix could go all the way down to 10 or so.

    So this creates somewhat of a dilemma right? By actually making predictions in viol you are actually indirectly making predictions on the underlying direction as well or at least you should be.

    Back to the relative viol question. As an off floor trader who can pick and choose which options you want to buy and sell, by always buying options that are cheap and by that I would say options where the underlying is weak and not strong but viol has not caught up to it yet and vice versa selling options where the premium is high on strong stocks, you will then hedge yourself much better then just buying cheap viol or selling expensive viol.

    I hope I did a good job of explaining to you the concept of volatility. i have met many many option traders and I find that maybe no more then 2% to 5% tops really understand volatility.

    It's funny there are so many quant guys out there that get paid so much money to create viol models that I think are so worthless.

    If you have any other questions, let me know.
  7. Mav,

    Great explanation of volatility in the real world. I too view implied volatility through the prism of market direction. Indeed, that is among the main reasons why I personally don't like long straddles, despite their being the "textbook" play in a "low vol" market. The dynamics you point out, in my mind, simply make trading them almost a loser's game from the outset. As you explained, even with a rise in IV, it's often more a matter of gamma bailing you out than it is of vega making the trade profitable. And the theta risk is simply too much for my tastes. As such, it has always seemed to me that if one were truly agnostic on direction, a better vega long alternative would be to use synthetic straddles comprised of long stock/long puts. Of course, I'd be interested to hear your thoughts should you have a different take on that.

    Thanks again for sharing your insights.


  8. MDCigan



    Just wanted to post a huge THANK YOU to you for your recent posts. I really appreciate your thoughts.

    I have a MBA in finance, and have traded options mostly successfully for awhile, and thought I knew just about everything. Reading your posts, I realized I still have more to learn.

    Anyways, my background is that I currently work as an investment analyst managing portfolios that are long stock and mutual funds, but my personal trading is mostly option strategies.

    I've come up with some strategies that I think blend together fundamental, technical, and volatility analysis to hopefully maximize "edge".

    Once I get some damn extra time, I'd like to post some of them for hopefully some critical analysis and feedback from somebody of your experience. Some of them directly relate to what you've mentioned about IV and stat vol decreasing as an underlying trends up smoothly and increasing as it falls.

    One last note. I've noticed option traders in general tend to approach option trading from one of 3 boxes that they rarely venture outside.

    The first group trades almost exclusively long calls and puts on a short-term basis based on TA but almost always ignore any fundamental or volatility considerations.. The second group trades longer-term strategies based mostly on FA but almost never considers volatility. I find that the second group is sometimes populated by analysts and portfolio managers who come from a traditionally long and fundamental biased model of viewing the markets. The third group trades almost exclusively volatility relying perhaps on a smidgen of TA and almost no FA. I find that the third group is often former market makers and floor traders.

    My thought/contention is that perhaps the "maximal edge" lies in combining all 3 together by either diversifying across different types of trades in an overall trading portfolio, or blending the three together. Example, you are long-term bullish on underlying XYZ and think IV is too low. Set up a trade which is slightly delta positive (to be hedged to downside), long gamma, long vega.
  9. mdc,

    check out the futures magazine article about pairs trading in stocks (Nov 03) which instead of putting on the stock pair will sell/buy the straddles based on relative IV between 2 stocks.
    Sorta like what you are referring too
  10. Maverick74


    I'm happy to hear everyone is getting something out of this thread. I'm just doing my part in keeping the option threads alive and well and making sure they remain the best threads on ET.

    I think you have to view options as a whole portfolio rather then each position. For example, as a rule of thumb, I would never want to have short gamma on individual equities unless I had like 100 of them spread out. I rather have negative gamma on index premium and lots of it.

    On individual equities, I like to have a wide assortment of stuff. There is nothing wrong with long straddles per say. You just need to have a lot of them. Just make sure you have an equal number of neg vega plays as well so your whole portfolio is not all long vega or all short vega. This is why I like short calendars so I can be long gamma and short vega. I also do straddle and strangle swaps and reverse calendars. Also ratio swaps and various backspreads. Condors are good as well as iron condors.

    The key is to look at the portfolio as a whole. Also make sure to lean your deltas in the direction of your vega. So when your long vega, you lean long delta and when your short vega you lean short delta. Also, this is really important. Make sure you keep your delta to gamma ratio in control. In other words, it doesn't matter what the size is of your deltas but rather the ratio of your deltas to gamma. I like to keep mine at 2 to 1. Maybe on rare occasions 3 to 1. But 2 to 1 works best for me.

    Enjoy everyone. Remember, with options you can do anything. There are so many combinations and permutations just make sure you know where your risk is at all times.
    #10     Nov 8, 2003