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Welcome to Part 5 of my series on the Greeks. This article will continue the focus on Vega and how to construct your trade depending on your view on volatility and how to manage Vega from the outset.
I firstly want to thank everyone for the positive feedback on this Greeks series. In the last week I have had many people in seminars comment on the articles and how they are helping them. That inspires me to go even deeper into this wonderful topic. Below are four bullish trades, on Apple Computers (AAPL), created in backtest mode in Optionetics Platinum on March 10th, 2008. This was a point where Apple climbed over the next couple of months, and volatility fell. The idea of this study is to:
- Create bullish trades with both a positive and negative Vega
- Create bullish trades that are almost Vega neutral
- Create very similar bullish trades, but with Vega’s of opposite signs.
- See how all trades faired after Apple climbed.
- Compare the Vega of each trade, with the same amount of dollar risk (approximately $1500 each trade)
Chart 1. OTM Long Call
click chart for more detail
This Long Call has the highest Vega of all. On the Volatility fall alone this trade will be the most affected. However it also has the highest delta 105.96, and will make more money than any of the trades.
Chart 2. Bull Call Spread
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The Bull Call Spread above has a much lower Vega of only $5.57, for the same dollar risk, but of course the trade off here is that it was a lower delta of only 79.83, meaning for every dollar move up, this trade is making approximately $25 less (initially) per dollar than the straight Long Call. Converting the Call into a Bull Call spread is the easiest way to hedge against a volatility drop.
Chart 3. OTM Modifly
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Charts 3 and 4 are a little more advanced and take some sharp eyes to see the differences. The deltas in both the Modifly and the 2-3-1 Ratio are almost the same, but for the same risk, and much the same picture (of risk to reward), one has a positive Vega, and one negative. Either way, for a $1500 trade, a Vega of positive or negative $3 is still quite hedged. The difference is though, the trade with the negative Vega (which is good for us here) also has a negative Gamma (which is not so good), meaning that the Delta will get smaller with each dollar move up (making less money from direction). But the third tradeoff is the one with the negative Gamma also has a positive Theta, meaning we make money from time passing by. But is the 33cents of positive time decay (in chart 4) worth it to have a Delta that is slowing down?
Chart 4. OTM 2-3-1 Ratio Fly
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So let’s see how each trade faired. I moved the date to March 31st, 2008, where volatility had fallen to its low, and Apple was at the end of a bullish run.
- The Long Call was in a profit of $3264
- The Bull Call spread was in a profit of $2068
- The Modifly was in a profit of $2055
- The 2-3-1 Ratio Fly was in a profit of $1497
Cleary the Long Call won, and although it would have experienced more of a loss from volatility crush than the others, its Delta far overrode any losses on volatility crush or time decay.
Manage your Vega!
Matt Baker
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