Vega Minded Adjustments

Chevy Vega

Spring break for my neighborhood arrived last week.  Schools were closed and many folks were traveling….including me.  Mexico had pretty much the same temperatures we had in the Chicago area before we left.  No trade winds in Chicago however, though it is referred to as The Windy City.  That reference is not to a weather phenomenon but to the endless banter of the Chicago political system.  I prefer trade winds over political winds every time.

Nearly all options positions have a vega exposure, either long or short.  Butterflies, condors, spreads – you name it – they all have exposure to changes in implied volatility.  When we initially model a trade, we can look carefully at the vega risk and determine needed changes to the trade’s structure.   One vega adjustment approach is called “delta leaning”.

Keep in mind that, in the world of equities and indexes, implied volatility typically rises as the underlying goes down in price and vice versa.  Implied volatility tends to go down as the underlying rises in price.   This phenomena is modeled in the OptionVue software and is called “constant elasticity of volatility”, or CEV for short.  Delta leaning takes advantage of CEV and can help us mitigate vega exposure.

For example, in an equities or index options trade that is short vega, consider leaning the delta a bit short.  This would capture some extra profit on a down move and thus offset some losses due to the typical increase in implied volatility. Of course, an upward moving market has the opposite effect.  Our extra short delta will lose a little more, offsetting some gains we might expect from our short vega during falling volatility.

For long vega positions, consider taking a slightly long delta position, offsetting falling volatility in rising markets and vice versa.  Be careful not to take too much of a delta position where we begin to root for the market in the direction of the deltas.  Consider a delta number equal to around 10% of the total vega.  The goal is to hedge and not speculate on direction.

Steve Papale is a mentor with DiscoverOptions, the educational arm of OptionVue Systems.  Inquiries should call 847-816-6610 or email info@DiscoverOptions.com.