Using Option Vega to Increase Returns and Decrease Risk
Aug 23, 2023
Of the first-order option Greeks that we use daily, option vega is easily the most hidden of the bunch. It’s easy to monitor delta, and it’s no less challenging to keep track of theta. But vega, however, operates a lot more behind-the-scenes with our positions. Still, it is important to recognize the role that it plays, and then apply that understanding to increasing your portfolio return or decreasing your portfolio risk.
The most critical aspect of utilizing option vega to improve your returns is to recognize that overall market volatility is almost always (over 80%) in a state of contraction. This means that positions that are short vega (or negative vega) will benefit from this volatility contraction, while positions that are long vega (or positive vega) will be hurt by this volatility contraction.
Therefore, to take advantage of this and generate consistent returns with our positions, we much prefer to sell far more options than we buy. By selling options, and establishing short premium positions, we end up carrying negative vega positions because short options are by definition negative vega positions.
As a result, the natural tendency of market volatility fits nicely with our short premium portfolios and has a positive impact on our portfolio returns from the fall in option prices that result from volatility contraction.
As is the case with every discussion we have around controlling our portfolio risk, the number one line of defense in keeping your risk under control is position size. Before you can ever think of how delta, theta, vega, or any of the Greeks' impact your risk levels, you need to make sure that your position size is in check.
Staying small on order entry can fix a lot of problems before they start, and getting too large on order entry can quickly limit what risk mitigation tactics might be available to you.
Once your position size is in check, however, the most effective way to harness option vega to reduce risk shows up in how we utilize implied volatility rank (IVR) to find opportunities.
Given that a short premium position’s negative vega will cause the biggest problems when volatility expands rapidly, we much prefer to wait until IVR is elevated before we enter the trade. So, an IVR of 60 is better than 40, and an IVR of 40 is better than 25, and so on. By entering a position when volatility’s relative standing in relation to itself is higher, the probability of having to absorb a rapid volatility expansion is lower than it would be if IVR were low.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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