So I've recently started to look into options trading since I'm getting old ->less intraday scalping -> more longterm positions -> more sources of edge needed. At the moment I'm studying a couple of positions I want to trade in different market scenarios to express my views on vol and forward curve. I like the concept of vega convexity for low volatility scenarios since it's far easier to manage a vega neutral/+vomma position opposed to just buy the straddle and hope for the best. However, I'm really struggling to find a good approach to establish correct hedging ratios. Some sources suggest to asume a flat skew, go 1 ATM straddle out to find the wing strikes and hedge to neutral. Other guys like to use the actual implied vol and buy the 20 delta wings in a vega neutral ratio. Some other guy said to just calculate vomma over various strikes, select the strikes with highest vomma as wings and buy them vega neutral with regards to the body. All that made sense to me somehow, but I realize how much of a 5year old I am when it comes to options. I know that there are much more factors to be considered such as sticky strike/sticky delta and skew dynamics. So I'm not really into rules of thumb here, I want to get a deeper understanding. Any pointers in the right direction (comments, book recommendations etc.) are really appreciated.
You can toss the terms around in the right ways -- I don't think a book is going to do anything for you. I think you need to cement these things in your head with real-life lessons. I think it's plain that you need some skin in the game, to watch and to glue into your ganglions what works, where, and when. The markets you trade will likely differ in how they deal with these more esoteric greeks. And what's more, they will likely differ within themselves: what worked in Spring may fade by Autumn. That doesn't mean that there is not retail-exploitable patterns in there! No! But it does mean you need to be light on your feet (intellectually), and be ready to recognize a shift in market regimes. How do you do that? "Skin in the game."
Not quite the answer I was hoping for but perhaps it's time for a good old hand written journal again and trade a couple of small positions.
I know you’ve been in this game for a long time and thankyou your posts that have helped me over the years when I was looking at futures. I’m very new to options as well, but I have read everything I can find and modeled what I’m trying to understand. I do understand where you’re at because I’ve been trying to work this out myself, and what I know is there’s definitely a lot more to it. Reading a stack of theory text books definitely helped with the basics, including the curves for the Greeks that you are asking about. Sinclair’s books and others helps with applying the theory to model ideas before the ideas are executed in real life. You mentioned wings on a straddle to hedge it, and now it’s an iron fly. Hedging Greeks is a whole different thing, such as hedging delta by buying shares etc. 1. Width of the wings changes risk reward - bring the wing strikes in and the RR improves, but you cover a smaller implied move; push the wings further out and RR is lower, but a better implied move range, and cheaper to execute because of cheaper wings, so you need to find a balance. 2. Charts for Vega, vomma and dela vs strike for puts and calls can be found in Sheldon Nattenberg’s book. You would need to add the options positions to make the fly, and instead of looking at a profit and loss diagram where you see $ across the strikes, you would be adding the Vega etc across the strikes and seeing how that changes. These are only ideas as I am new to options, but maybe it might get the conversion started with the experienced traders here. Doubtless people will find flaws in my reasoning, but that’s ok as it gets the conversation started.
I hope you can find a way to make consistent profits with all this extensive knowledge. I find for the average trader, this is making the business if trading overly complicated. I have been on the side of the business since 2011. I have noticed consistently over time, that simple strategies work the best and making options overly complicated are just that, too complicated to work.
Guys, many thanks for the condolences , I really appreciate that. There are a couple of things I'd like to add though: First, I find that information on options that's out there for retail is really incomplete and some things are just plain wrong or suboptimal. I never understood why anybody want to get iron condors or short naked wings when the juiciest decay is ATM which is also less risky, because you're selling downside curvature (gamma becomes less prominent when the option goes from ATM to OTM). Calendar spreads are propagated as "low risk" method to harvest premium while nobody talks about the risks associated to the forward curve and vol term structure. When I started trading, options were just cheap limited risk leverage. Nowadays some even understand what gamma is. I wonder why everybody thinks that delta is the only greek that has a second order derivative. Vega also changes with moves in IV, the underlying and time to expiration. That's not complex, it's only seen as complex because it's a blind spot in the education business and the sales side. I've never heard a broker say "well don't sell naked calls on biotechs because you'll get tripple fked by short gamma, vomma and jump risk". It's common knowledge that it's a dumb risk, but nobody knows why. It's also common knowledge that you sell wings 10-20 deltas OTM and 30-60 days out. But why? Ever heard of gamma rent? If you did, you probably could specify the best strike and TTE for your option. It's again common knowledge that you buy a straddle or a strangle when you want to be long vol...but the straddle as a position is just dumb as hell. You have massive vega risk and you lose decay. So when you sell the ATM straddle and buy two OTM straddles vega neutral, you profit from vega convexity -> when vega goes up you're long vega and when it goes down, you're short vega and you profit from decay. Harder to manage, yes but after all, it's just a butterfly with more wings. Retail strategies have one thing in common: You need to be right about the direction of the underlying with them and they are the exact oposite of how market makers are managing risk. Joe Public sells 10-20 delta wings for "income" and buys ATM for "cheap leverage". John Doe trades verticals for delta and buys calendar spreads and butterflies for the decay. Market makers and smarter people hoard wings so they can sell juicy ATM premium, trade risk reversals or combos for delta, only get into calendars when they want to trade term structure and trade butterflies for skew and delta. And that's why retailers don't have a lot of edge, they trade options positions as strategies or proxy for the underlying and not the options themselves. I want to trade options because there is edge in options. In futures if you think that JUN is too rich vs the DEC, well you sell the JUN, buy the DEC and your position will behave like an outright contract. In options when you think that vol is too low you can't just buy vol and wait until it goes up. There are a myriad of posiibilities to manage positions but in order to do so, you need to know how all this stuff works...and that's why I want to learn
Lots of people look at the second and third order greeks. Lots of people look at cross greeks as well. But they generally run very large books where those effects are meaningfully monetizable in the scope of their pnl. An exotics desk may look at vomma while pricing a 10 year insurance structure that has billions in notional. Vomma might explain a few million dollars of their pnl. Other than an intuitive concept, I never understood why a retail trader would worry about greeks beyond Gamma, Theta, Vega, and Delta. Everything else can be modeled by shocking your book.
I agree. As a small local market maker, I liked to have most of my risk on one greek at a time, where I thought the edge was. Most of the time, that was Vega. There was always supply in the back months and often demand in the front. It was often not up to me what my positions looked like, as we did not initiate orders, only traded with the public. We could affect the prices we traded at and when we hedged. A public customer has the ability to decide when, what and at what price, without the member requirement to make markets. Their positions are often simple (I had positions in AAPL on almost every strike and in every month). My positions required netting out my greeks to see my risk and adjusting for Vomma, even though I did not know what Vomma was. Most customers put on spreads and view them that way until they unwind them. We did not. After we did any trade, it was like adding ingredients to soup. I have said this many times before. Public customers that look to put on a spread first, without an assumption of what the stock will or won't do over a period of time (Many option mentoring programs do this), tend, IMO, to look at option trading backwards and do not consistently make money. So your comment on what type of spread you prefer in advance, might work well for you but maybe not everyone. I suggest after having a process for an expectation of stock movement or lack thereof, it is best to look at current prices with fresh eyes and do what fits your expectations with the current options prices-or avoid the trade because they don't fit your requirements. Basically, with respect, I disagree with your comment,"And that's why retailers don't have a lot of edge, they trade options positions as strategies or proxy for the underlying and not the options themselves." IMO, you have to do both. Bob
Hi Robert I think I came across all wrong. I definitely don’t know much about options, but I thought I could help the OP by mentioning the books recommended on this forum. They’ve helped me see the broad outline of how things fit together, and begin to understand where and why to place the wing strikes. But it looks like he understands the basics anyway. From a retail perspective, I definitely agree with you that it’s all about understanding what’s happening with the underlying, then applying the relevant option strategy to make a profit.
Knowledge is always good. I was not commenting on your post. What I run across are those that do not care about how options are valued and how they change over time and the other side where the trader/manager needs to know everything. EVERYTHING! There was one guy in particular, no names. He learned every option term. Put together a detailed pitch book using as many terms as he could. To me, this was a bit of a red flag. There was no strategy that made sense. There was no focus. I suspect he never raise more than he could from friends and family because the goal appeared to sound smart, not offer a winning process. Making money in the market is all about finding a process that helps find edge and take advantage of it. Some type of predictive model. Anything that works. Then you have to understand how options behave to take advantage of it using options. I made money for 25 years as an Option Market Maker, never even heard the words Second-Order Greeks or Third order greeks until a few years ago. But I had a practical understanding of the relationship between the options I traded, how they were affected by general market conditions and upcoming events that created uncertainty. bob