TRADING TECHNIQUES
Risk Management By Greeks
Reducing Risk With Delta-Vega Hedging
by Seongjin Cho and Ingyu Koh
Predicting market movements with options can be profitable but risky
-- here's how to make it safer.
The size of the option market has increased
significantly, thanks to high leverage. Many investors have come up with
various portfolios based on individual analysis in hopes of gaining profits.
In particular, strategy combination of options is a popular method among
traders and makes use of an option's time value for gains. Essentially,
you take a short position and get rewarded for holding your position as
time passes as long as the underlying assets remain unchanged. If there
is a drastic change in the underlying asset, however, there is a risk of
a large loss.
As we all know, it is difficult to predict which direction the underlying
assets will move. Because of that, it is necessary to eliminate or at least
minimize the directional effect of the underlying asset. So it is crucial
that you offset the impact of the underlying asset and volatility.
RELATION BETWEEN FUTURES AND IV
Here we discuss the results of our analysis on the Kospi200 futures
and option data. We look at the relationship between Kospi200 futures (underlying
asset) and implied volatility (IV) of the Kospi200 option (volatility).
We then explain how this relation can be used to reduce risks through delta-vega
hedging.
If there is no change in volatility, the price of a portfolio is affected
only by a combination of the underlying assets and time. A short straddle
position (SSP) is a nondirectional strategy where you sell a put and a
call of the same underlying instrument. The call option has a negative
delta while the delta of the put option is positive. In effect, the call
option offsets the put option achieving delta neutral, meaning the portfolio
is no longer exposed to changes in the underlying assets.
However, there is still volatility to consider. To neutralize vega in
SSP, you need to use delta since the call and put options have positive
vegas. This is called delta-vega hedging. To be functional, one condition
for delta-vega hedging is that the underlying assets and volatility must
be correlated. First, let's clarify what underlying asset and volatility
refer to in this context.
...Continued in the May issue of Technical Analysis of STOCKS &
COMMODITIES
Excerpted from an article originally published in the May 2008 issue
of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
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