Building vega hedges

[stevenpaul]

Could anyone suggest a spread of some kind that acts like the Vix, a trade that is sensitive to volatility alone?

My main play is ATM bull put spreads on the SPX coupled with OTM bull calls spread on the Vix futures, financed for half the credit of the bull put. How to optimize this trade is a thread in itself. My main interest now is in branching out.

Vix derivatives aren't useful as hedges in just any market, being specifically correlated to the SPX. What kind of trade can be structured to increase in value if volatility picks up, without other Greek sensitivity?

Just to be fair and suggest something, I thought of using 10% OTM put side calendar spreads as a hedge: The should be long vega, and delta helps if the trade moves into the profit zone. The idea is to buy an ETF, say the XLE, and if it pulls back 10% at or around expiration, the calendar makes up for the losses. It's cheap enough to put on at least.

But I wouldn't be writing if I thought that was good. First of all, it could blow way past the 10% mark, or undershoot the mark. Calendars don't make much money unless the prediction is spot on.

Any thoughts on structuring some kind of synthetic Vix for any and all markets to use for hedging directional strategies?

 

[guru]

Believe it or not but there simply isn’t a better hedge than plain & simple SPX puts, no matter which way you slice it.
But what’s more important is what you trade in terms of bullish setups that you’re hedging. Each can be hedged with different SPX puts, while some are not worth hedging at all, or not even worth trading.
So when you trade something not worth trading then buying a hedge won’t do anything besides being an extra cost.
There are some creative setups that are good hedges, but in the end the creativity is in the setup not losing much money and therefore being a mild bet on its own, which then still needs to be hedged with an extra put. Basically every good/hedged setup does include an extra put. And every even a mild hedge also includes an extra put.

Secondly, everyone’s concern is that puts do lose value, so you have to plan your trade for the time when the put has sufficient strength. For example a 6-month otm put may hedge you for only couple months, so you’d have to plan 1-2 month trade that can be profitable within that time span, basically looking at 1-2-month performance of the trade vs 6-months, and replace the trade every 1-2 months, either closing or rolling all legs including the 6-month hedging put.

Third, the total delta of your positions/ option combination is a good guidance. Don’t shoot for more than 0.15 delta in terms of your bullish bet combined with a hedge. The higher the delta the harder it is for it to turn from positive to negative (profitable on the way down) when your put/hedge kicks in.

Timing also matters, as currently SPX puts are still expensive due to recent high VIX regime but quickly losing value as we’re moving to low VIX regime.

Finally, it’s very difficult to hedge against mild market drops of less than 5% or even 10%, and it may not even be worth it. So buying hedges is useful mainly against larger crashes. Otherwise you’re simply making a bullish/bearish bet that is not further hedged.

 

[Magic]

Good question to ponder. I don’t think there’s any silver bullet in the SPX/VIX complex though. Any attempt to reduce carrying cost on the hedge will also reduce its PnL when the bad times finally come.

If you isolate the risks you really want to offset you can usually save a bit of money. I.e. -1 otm x +2 further otm put ratio won’t cost nearly as much to carry long-term but you are going to need more downside before it kicks in.

If you are already going to be out before we see -10% then just buy a put vertical instead. There’s definitely some relative value to be found at times but don’t forget that oftentimes having less deltas or just sizing down your risk is better than trying to get too fancy.

 

[stevenpaul]

Thank you, to both of the above contributors. Magic and Guru. Helpful insight.

A question on some of the Guru's points:

But what’s more important is what you trade in terms of bullish setups that you’re hedging. Each can be hedged with different SPX puts, while some are not worth hedging at all, or not even worth trading. So when you trade something not worth trading then buying a hedge won’t do anything besides being an extra cost.

Can you list an example of a bullish setup not worth trading? Assuming the outlook is bullish, what sorts of setups would you avoid?

There are some creative setups that are good hedges, but in the end the creativity is in the setup not losing much money and therefore being a mild bet on its own, which then still needs to be hedged with an extra put.

I'd like to know what sort of creative setup you have in mind here. I gather this is something with a hedging effect built in. That could be said about all spreads, but I assume you're referring to some kind of finesse to spruce up the standard strategies.

Secondly, everyone’s concern is that puts do lose value, so you have to plan your trade for the time when the put has sufficient strength. For example a 6-month otm put may hedge you for only couple months, so you’d have to plan 1-2 month trade that can be profitable within that time span, basically looking at 1-2-month performance of the trade vs 6-months, and replace the trade every 1-2 months, either closing or rolling all legs including the 6-month hedging put.

What do you mean by sufficient strength? I would think the put would become more responsive as time wears on and gamma grows. Do you mean the gamma of a 6 month put is a better value for the money than say a 1 month put?

Third, the total delta of your positions/ option combination is a good guidance. Don’t shoot for more than 0.15 delta in terms of your bullish bet combined with a hedge. The higher the delta the harder it is for it to turn from positive to negative (profitable on the way down) when your put/hedge kicks in.

I like the net delta of 15 principle, which I had never heard. Thanks for offering something so concrete to work with.

 

[guru]

Can you list an example of a bullish setup not worth trading? Assuming the outlook is bullish, what sorts of setups would you avoid?

Well, I wrote a program that figures out what option combos to trade, and they can get pretty complex, and there aren’t that many of the ones worth trading, while I don’t see the “bad” setups so I wouldn’t really know those. While I just don’t see too many commonly used option strategies at all, so most of them may not work well. Also many option traders do say that after years of trading they’re barely braking even, so we could conclude that trading options without some sort of edge isn’t worth trading at all...
Though an example may be a basic spread (say a call spread when you’re bullish), which my system does propose occasionally, but only as 1-2 year LEAPs and unhedged, so both trading shorter-term spreads (say less than a few months) or hedging them may not be worthwhile. Some calls or a small number of shares can be hedged but with specific proportions when wanting a direction (besides basic delta hedging). Though buying unhedged calls can also work, just like a casino bet that doesn’t need to be hedged because the amount of bet is the max loss that acts as a hedge against a larger loss. Actually spreads are also bets that shouldn’t need hedging since they limit the loss. And since every option combo/strategy is a combination of spreads (and/or optionally an option like a call) then it can be argued that none of them need hedging. Go figure. Though this could also lead to using a hedge against multiple bets or series of bets, rather than a single one.

Also, the “bullish outlook” should not matter much because this is usually priced into options, so theoretically your odds may not be better by having bullish outlook, especially if it’s the same outlook as everyone else’s.
Finally, the same option strategy may work differently in different volatility regimes, or even in a single vol regime but at different vol levels. So sometimes a strategy may be worth trading and other times not. And the same strategy may not be worth trading when the option pricing skew adjusts to the odds, like when everyone has bullish views and calls become more expensive. So I have almost no strategies that show up repeatedly every day.

I'd like to know what sort of creative setup you have in mind here.

I was actually referring to your own example of a put calendar, which is not a hedge but could become a hedge if you’d add an extra put, but then it would also become a hedged bet rather than a hedge, and probably not a great bet when you’re bullish. Another example could be a wide put spread or a butterfly, which theoretically could partially hedge you against specific level of fall, but in the end this is also a bet, and one that could use additional hedging.

What do you mean by sufficient strength? I would think the put would become more responsive as time wears on and gamma grows. Do you mean the gamma of a 6 month put is a better value for the money than say a 1 month put?

Yes, and maybe not exactly the strength but value and own durability by not decaying too fast. Basically I rarely see short-term puts as hedges, usually longer-term. But this could also be specific to my system and combos that I’m trading, which usually are longer-term, and a 6-month hedging put (as an example) can be shorter or longer-term than the other legs within my strategy (sometimes I may have 4 legs with 4 expirys), so I may not have proper insight into using shorter term puts as hedges, even though I’m generally aware of their benefits and may look into them in the future. Though I’m also not limiting my system to long-term stuff, while it just doesn’t show me many short-term strategies or hedges. Sometimes the time in trade (exit) may be short-term like within a week or two, but still using longer-term options.

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