Minyan Mailbag: Hedging Falling Vols
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A lot of the trades I like to implement are delta neutral, long gamma, and relatively theta neutral. For example, long OTM 07 puts, Short smaller amount OTM 06 puts, and long the appropriate amount of stock to be delta neutral. The objective is to trade back and forth the best I can. The largest amount of risk in these types of trades is the large vega component. Other than trading the position each day profitably, do you have a preferred method of hedging the volatility risk associated with this type of structure?
Thanks and your insights are great!!
position in otm
This type of trade by its nature assumes this risk: by creating a theta neutral and long gamma structure you must almost by definition have vega risk (the risk that long term implied volatilities will drop). So when you do this trade you must "like" the price at which you are buying it. The second thing I would look for is an "edge" between the option prices you are spreading, i.e. selling the shorter term option at a higher implied volatility than the longer option. If there is enough of a spread, vega can actually drop and the trade will not lose money and may even still make it.
This opportunity sometimes occurs when earnings are expected and the market bids up shorter term options relative to longer term ones. But more likely it occurs when there is significant news expected out in a company and the market thinks it knows the timing. I described a trade I did in Eli Lilly (LLY) where I bought actually 2007 options in LLY at a 20% implied volatility and sold options for June expiration at 55-60% implieds. This trade looks like it had significant vega risk (and produced a very large positive vega number theoretically), but because the difference in implieds was so large it actually didn't. The market, as usual, was wrong on timing of the news of a court decision, and the announcement was not made until just last month. I was able to roll my short options at significant premiums several times. After the announcement finally came it was a non-event and all the short term options were crushed in price. Now I am left with my long LLY 2007 options and they did not even drop in volatility at all and was able to hedge those out in 2007 at a 22% implied.
So the trade you describe is a good trade when you are comfortable in owning the long term volatility outright and can get some type of higher implied price in the shorter term option. The above LLY trade was actually positive theta and positive gamma since the options were so mis-priced. Theoretically it showed long vega, but realistically I did not think I was long that much.
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