How should you manage volatility (or vega) risk on time-decay strategies during a high-vol market? This post provides some rules-of-thumb and other tips to help you plan a time-decay strategy with volatility bumps in mind.

This excellent question comes from TradeKing client Pauly B. He posed the following scenario: he’s trading all credit spreads and condors, both strategies looking to capitalize on time decay, ideally in a nice, snoozy, low-vol environment. His question deals with quantifying his hedging strategy: “How much should I be looking at reducing my portfolio vega overall by hedging with calendars or other long vega plays?  I have heard different approaches, reduce by half, and reduce by a third and so on.  What’s your spin on this during this high vol environment?”

I wish there was a golden answer to this, but there’s not. If you look to hedge any Greek, the question then becomes how often do you re-hedge? That is, if you bring vega down to -100 and then it goes back to -200, should you hedge again? or if it becomes smaller do we take the hedge off? These are all feel questions.

By trading short spreads, you are already making a statement about volatility with the initial trade. I don’t like to encourage over-trading, so if I sell a credit spread I usually just look at the price as opposed to the vega to determine when to hedge or exit the trade. I wouldn’t try to play market-maker here, especially with spreads.

There is a specific case to mention here: when an underlying is going against you on a credit spread. Let’s say you’re dead wrong on a short 80/90 call spread (sell 80 call, buy 90 call); the stock is now at 95 with a month remaining. For this trade you’d like implied volatility to go higher, even though it is a short spread. You would lose less in this instance if implied volatility rocketed. It’s only when the spread is going in your favor that you really want IV to decrease. Many traders don’t think about how Greeks change for you position as the underlying moves positivity or negatively against the position.

You can map out the effects of volatility swings in advance using our Profit + Loss Calculator under the Tools menu. Plug your short spread in the P + L Calculator, move the stock projection past your long strike (so you are losing) and then look at vega, the Greek measuring volatility’s effect on your trade - vega will be a positive number. Move the stock price to a winning position, though, and vega will go negative. Good thing to know in advance when times get hard.

In this case, if I see something has gone against me but volatility increased, I would be tempted to get out before the volatility comes back off. To me it is more important to understand the dynamics of vega then to try to manage it. Ultimately you already did do some managing when you decided to do a spread instead of just a single option.

Read on…

We offer tons of good educational info on these subjects, if you’d like to brush up further. Take a look at the following:

Vega is the Greek measuring the theoretical effect of volatility changes on your options position. In my three-part series, I defined vega, talk about the usual characteristics that can lead to options with large vega, and explore the importance of watching vega for your total position, not just one leg.

More recently I blogged on position vega and calendars – that’s a good companion read to this post.

What’s a calendar or condor, you ask? Head over to The Options Playbook under Education – look for Plays #27 and 28, Long Calendar Spread (w/ Calls) and Long Calendar Spread (w/ Puts) respectively. You’ll find Long Condor Spreads, another time-decay strategy, under Plays #24 (w/ Calls) and #25 (w/ Puts).

To learn more about how calendars can be a useful play during low-volatility periods like the post-earnings season, check out my colleague Dan Sheridan’s All-Stars post Trade the post-earnings snooze with calendars.

If you’re more of a visual learner, go to Education > Resources > Videos and check out the Calendar Spreads (Long) educational video.  You might also find the Volatility and Probability webinars there useful.

Hope this helps!

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

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I like to think of trading credit spreads and condors as being a net seller of options, but with defined risk as opposed to naked shorting which has unlimited loss potential.  While I think its always a good idea to be aware of the greeks and how they impact your position, I must say that I totally agree with your statement about focusing mainly on the price instead of the vega as to when to exit a trade.  When you are selling options you are going to have negative vega.  This may not be all bad however, because for example if you sold a vertical call spread and the volatility increases because the stock had a sharp drop in price you are actually OK because the price of the stock moved away from your short call.  Then you can sit back and wait for the benefits of your theta (time decay), which is essentially what you are looking to benefit from when you sell a credit spread.  The increase in volatility will probably not hurt your position in this case if the voltaility increased because of a sharp drop in the price of the stock.
There are some repair strategies that can be used for credit spreads and condors when they move close to or in the money as you mentioned.  I prefer to follow the price of the underlying when considering making a hedge on the position or trying to repair the position.  When you begin to focus on the greeks too much you can lose sight of the bigger picture and can get caught in a cycle of constantly trying to adjust your position vega or delta.  There is also the possibility to roll your credit spread to a future month, which can help mitigate losses if the underlying stock recovers.

Speaking of rolling spread trades, is there any news on the ability to roll a spread from one month to another month as part of a single transaction?  I've asked this question before and you had mentioned that this should be available this year.  The reason being that you can preserve your original margin requirement if you have a losing trade and are able to roll the trade in 1 transaction for a small debit, thereby keeping the spread alive for another month.  When you are required to do the trade in 2 separate transactions your margin buying power takes a huge hit when you close the spread for a loss and then you can't open the same amount of contracts in the following month because of the reduced buying power. 

Thanks for all your informative and interesting posts Brian!

Hello Condotrader,

Thanks for your follow up and comments. The rolling spreads feature is being worked on as we speak! I just had a discussion with a TK programmer about it yesterday. I hope we'll have it done and on the site before June is over, but don’t hold me to that.

Regards,
Brian (Og)

Thank you Condortrader and Optionguy. 

I have been hit with vol crush in some of my calander spreads and I then have to make a decision if I want to continue in the trade or not.  It comes to a point where do I want to redeploy my capital rather than adding to the trade to get my greeks in line. The vol drop has now caused me to loose my profit target because of vega problems.

This was a point I was getting at.  Price hasnt hurt me but my long vega has.

I understand watching price is equally important but on calanders there is that unique vega risk out there where sometimes I have to make a decision to continue in the trade or exit.  Your right price is normaly your problem but occasionally vols can hurt you too.  Just trying to get some view points.

Thank you