Have you ever heard former or current market makers talk about the way they manage risk? If so, you know that when they take the other side of our or institutions' trades, they accept added risk. They move quickly to offset that risk.
You may have seen examples of their resultant positions, either on a trade matrix or a profit/loss graph. Those positions may not have looked anything like the discrete calendar, credit spread, butterfly or other strategies we retail traders employ. Some of those familiar strategies may be embedded inside a conglomeration of trades that it might be difficult for most of us to untangle.
I personally dislike having my RUT iron condors and calendars or my OEX iron condors and iron butterflies in the same account, much less as part of one larger conglomeration of RUT or OEX positions. I am one of those people who doesn't like my steamed asparagus to touch my risotto on the plate, and I certainly don't like my calendars to overlap my iron condors, which overlap another trade or two. I want everything all nice and discrete, not touching.
Market makers, on the other hand, may throw a calendar into the mix to manage the Greeks or plump up the profit/loss expiration graph at a certain point. What market makers are doing is managing by the Greeks, offsetting delta and other risks. They may not care too much whether the position that results has a nice little descriptive name.
Do we retail traders have to do that? No. It's probably not a good idea for anyone other than highly experienced traders to manage by the Greeks, students in the Sheridan Mentoring program are warned. I can remain my little slightly OCD self and still trade effectively. Those of you who feel overwhelmed by the mere mention of the Greeks of option pricing can relax. However, if you're one of those people who feels overwhelmed by the thought of the Greeks, I invite you to listen to my own journey toward utilizing the Greeks of option pricing. The tale meanders a bit, but so did my journey. I want to ease you into thinking about how the Greeks can help your trading, just as I was eased into that knowledge.
My first few years trading, I had a casual understanding of how the Greeks worked. However, I certainly wasn't managing anything by the Greeks and paid little attention to the Greeks of my positions. I was still day trading, buying long calls or puts. I figured out through trial and error that the option that was the best balance between spending as little money as I could and getting the most bang for my buck when day trading was a slightly out-of-the-money option.
About that time, I was re-reading McMillan's tome, Options as a Strategic Investment. I noticed his admonition that day traders should either trade the underlying or be utilizing options with high deltas. I had just taken my first baby steps toward utilizing the Greeks. Through trial and error, I had been gravitating all along toward options that had a high enough delta to make my style of day trading have a chance at a profit.
Those options I preferred for my strategies usually had deltas with absolute values of about 0.70 or 70, after the 100 multiplier was applied. That meant that for about every point the underlying moved in the right direction, my option would theoretically gain about $0.70 in value.
My strategy at that time was mostly trading 3-5 point moves in the OEX. I needed a big enough delta that I could pay for the commissions both ways and also make a profit on at least a three-point move. I determined that I needed at least that 0.70 or 70 delta.
Over the years, lifestyle issues dictated that I move away from day trading and toward a style of trading that unfolded a bit more slowly. By 2003-2004, I was mostly trading iron condors. Then, one day, my broker asked me if I knew what my portfolio vega was at the moment. Iron condors are negative-vega trades. Early in the trade, at least, they'll be hurt by a rise in volatility. If, soon after I've entered an iron condor, prices move hard toward the sold strike on one side of my iron condor, the cost to buy back that sold strike is going to escalate more than it would if volatility weren't rising. My loss, if I am forced to exit or roll the spread, will grow more rapidly.
Usually volatility rises when prices drop hard, but it can rise if prices jump too rapidly, too. Most often, however, iron condor traders are going to be hurt more when they have to close out an in-trouble bull put spread than an in-trouble bear call spread.
I took my next baby step toward utilizing the Greeks. I learned to start paying attention to the vega risk. My broker suggested ways I could reduce the risk, by varying the types of trades I employed. I learned about others by listening to presentations on the CBOE and through my own study of various strategies. From my broker, from Sheridan's CBOE presentations and my own experimentation via paper trades and small live trades over the last several years, I started settings goals of varying my delta and vega risks by varying the mix of trades I employed. That's been a long journey and a hard one to travel in the historical market moves of the last several years, especially for someone who is cautious and moves slowly. This hasn't been a good time to take on risks associated with trading unfamiliar strategies in too big a size. I'm a little way down that road, but not to journey's end yet.
When I was still on that journey, I was taking baby steps on another parallel journey toward managing by the Greeks, probably one of the most important journeys in my entire trading career. When I had first begun trading iron condors, I'd used technical analysis to tell me where to put the credit spreads and then, to help me determine when they were in trouble. I wanted to sell my calls and puts just outside what I considered strong resistance and support. I knew they were in trouble when that resistance or support failed to hold.
Then I started noticing something important. Sometimes when that support or resistance was breached, it hurt my account balance a little to buy back those sold credit spreads and, other times, it hurt a whole lot more. Time seemed to factor into the equation. So did the speed at which the sold strikes were approached.
I needed a way to better quantify when I should exit a credit spread, when to take a loss. Obviously, the price point wasn't enough. It mattered whether that price point was reached early in the trade or the day before option expiration. Some people recommended a time- and price-based combination. If prices moved to within X points of the sold strike with Y weeks remaining before expiration, it was time to close it. The price could get closer as the time elapsed and expiration neared.
These suggestions were in fact somewhat clunky attempts to figure out how time and price movement combined to impact those credit spreads. However, these suggestions left out something important: the impact of volatility. If prices meandered up to within 20 points of my sold calls within two weeks before expiration, moving about a point or two a day, I wasn't going to pay as much to exit the positions, if needed, as I would if prices suddenly barreled that direction, moving 20 points a day.
I obviously still needed something more concrete to help me make exit decisions. I needed a way to quantify risk, a way that incorporated time, price and volatility. The Greeks provided that way, specifically the delta of my sold options. Volatility and the time to expiration impact the way delta moves, so all the information about volatility, price movement and time to expiration will be reflected in delta. I believe I may first have heard about using deltas to make exit decisions on iron condors on another of those CBOE webinars I listened to so often, most probably from former market maker Dan Sheridan.
Since then, I've modified the delta-based approach to my own trading style. Iron condor traders have many different styles, each with their pros and cons, but I most often want to roll my sold call spreads up when the absolute value of the delta of the sold call is 22-25 and roll my sold put spreads down when the absolute value of the delta of the sold call is 22-24. For me, that delta level represents the right balance between not adjusting too often and adjusting before the spread gets too expensive and the loss too large. That means sometimes I'm adjusting when prices are still far away from my sold strike and sometimes, when the prices are relatively close, depending on volatility and time to expiration. However, the price I pay to buy back the spreads is relatively similar each time I do need to adjust because the deltas of the sold strikes are similar. That way, I know how to plan. I know what I'm risking. I'm not risking paying $2.00 per spread to exit in one instance and $4.50 in another.
After my broker's question about the vega risk in my portfolio, I started noticing the Greeks of my total portfolio as well as individual positions. My portfolio was always full of iron condors. Deltas were rather neutral when I put them on, thetas were positive and vegas were negative, but when prices moved big, those deltas did, too. A move too far toward my bear call spreads meant that deltas got more and more negative and I was hurt more and more by the rally toward my sold strike. If prices dropped rapidly, I was going to be hurt by price movement but also by the negative vegas because volatility was going to rise. I started thinking about the ways that I might vary those risks so that sometimes a rise in volatility helped my position. I started thinking of ways I could mitigate the delta risks, perhaps by hedging with long calls or puts.
I was taking a few more baby steps toward managing by the Greeks. A couple of years ago, I started adding calendars to my iron condor trades because calendars are positive vega trades. They typically benefit from a rise in volatility. I started adding a few iron butterflies. Although they, too, are negative vega trades like the iron condors, it's a bit easier to manage the delta risks in iron butterflies than it is in iron condors. More baby steps.
I listen to those current and former market makers talking about how they manage their risks and I still want discrete, easily named strategies. I still don't want a conglomeration of trades so mixed up that I wouldn't even know how best to unwind it as expiration neared. However, sometimes I gaze ahead on the road along which I'm journeying and I wonder, wouldn't it be nice to have just one position that needed tweaking rather than many at the same time? Wouldn't it be nice to see by the Greeks when a position was about to get into trouble, when the risks were weighing too far on one side, before there was even a loss in the position? I could take action to ameliorate those risks. I could sleep easier.
Each day, I take a look at the total portfolio Greeks in all my accounts. Even if I'm not yet ready, either emotionally or through experience, to manage by the Greeks, I think about the positions that I might add just because the portfolio delta or vega risk appears to have grown too strong. I think about how negative gammas might impact the deltas over a day's time and whether my theta is large enough to undo any harm that a price or volatility change might cause. When the absolute value of the delta of a whole portfolio full of positions is under 10 and the theta is positive and in the many hundreds, I know I'll sleep easily that night. The thetas will be working in my favor while I sleep and the positions aren't in much danger due to price movement, unless that price movement is extreme.
I'm still just toddling down that road toward managing by the Greeks. I'm not suggesting that our readers do more than take baby steps, either. Subscribers don't need to have a degree in quantum physics or theoretical or applied mathematics to trade options.
However, a working knowledge of the Greeks of option pricing can provide us with valuable tools, allowing us to find the right option if we're day trading, assess risks in more complicated trades, plan stops and take other steps that benefit our trading. You can find archived articles about the Greeks on the Option Investor website. If you really want to go hardcore in the Greeks of option trading, you can buy James Bittman's Trading Options as a Profession. Just don't plan to read it in one sitting without going to sleep or feeling the neurons in your brain twist into pretzels. It's valuable stuff, but rather dense even for those of us who trade options.