I was paging through books looking for ideas for this column when I came across a section on risk management. I'm always interested in risk management, both for my own trades and for this column. I settled in to read the typical information about setting risk based on dollar amounts versus percentage amounts.

That's when the material diverged from the typical statement and honed in on something else. We all know about the risk from price movement in our underlying. However, fewer options traders think about a risk that may be larger and more important, especially in the beginning of a trade: risk from volatility changes. I've written about that previously, but the paragraphs I was reading reminded me that it's time to do so again.

That material was located in a section titled "Establishing Risk Limits" in Trading Options as a Professional. In that section, CBOE instructor Jim Bittman suggests that for some trades, we should be using initial position vega to determine if we can afford the risk in that trade. Vega is the Greek that measures how much an option's value changes with each percent point change in implied volatility.

Rather than paraphrase or quote Bittman, let's work through an example that will hopefully illustrate Bittman's thinking. He separates his examples in this section into delta-neutral positions with a stock component, neutral positions without a stock component and directional positions. For the newbie, delta measures how much an option or option position's value changes with each one-point change in the value of the underlying.

One prefacing notion was that a "neutral" position didn't mean that the position was risk-free.

For example, imagine a bull call debit spread on AAPL composed of the following strikes: +5 660 SEP 12/-5 670 SEP12, with this theoretical position entered Friday, August 31. This is not a trade suggestion, and I did not enter this trade but instead am using this to illustrate Bittman's cautions. Freeware OptionOracle's Strategy Summary shows that the delta of the position is 117.05, so it's far from a neutral position with respect to the delta. What could the trader do to neutralize this delta risk? The trader could sell 117 shares of AAPL. This would, of course, require a hefty account size.

Strategy Summary of Call Spreads:

The trade is neutralized, shown by a "Total Delta" of 0.05 and a "Total Vega" of -2.49. Does that mean that there's no risk to the trade?

Far from it, Bittman points out. Although logic would suggest that AAPL can't keep going up forever, there is technically no limit to the price to which it can rise, and those short stock positions will contribute to higher and higher losses, as indicated by the expiration risk graph.

Strategy Graph

I don't know many of us who would be willing to commit a hefty amount of money to short 117 shares of AAPL these days in order to neutralize 5 call credit spreads. However, this makes Bittman's point that a strategy that is neutralized at any one point in time is not without risk. "A trader therefore must estimate potential risk by considering other factors such as pending news and the possibility of a sharp stock-price rise. Such considerations are subjective" (328).

That was an extreme and perhaps unlikely example to be employed by most of us. I certainly wouldn't want a graph that looked like that in a stock that had been rising relentlessly, ahead of a rumored early September new product release. As we know today, AAPL has risen from its 8/31 levels, posting more gains.

As this article is edited about 12:48 pm EST on Friday, September 07, 2012, AAPL has risen to 681.84, and that trade, if not since adjusted, would be suffering a theoretical loss of about $1360-$1380, with the PnL bouncing around a bit as I type.

Savvy and experienced traders will understand that we would have had to have adjusted the number of shares shorted as AAPL moved if we wanted the trade to stay delta neutral. But it's a simplistic way to show that something other than just deltas must be used to assess risk when we enter some trades. Bittman has some suggestions, and we'll begin with those next week.