Quantifying Value at Risk (VaR) on Spreads

ogarbitrage

ogarbitrage

I've been trading credit spreads for a short time and trying to compare my returns relative to the entire portfolio and relative to the amount I am putting at risk.

My question is which is the best way to quantify VaR when selling option spreads? And I am defining VaR as the largest possible loss, assuming a 100% loss on a position.

For ease, numbers will be small. The two ways I am using are:

1) Sell X Dec 35/40 call spread for 2.00. Total VaR is $500/co., given the difference in strikes.

2) Sell X Dec 35/40 call spread for 2.00. Total VaR is $300/co, because the $200 premium is unrealized until opex.

My contention is to value VaR (semantic redundancy aside) based on #2, here's why. Given a $5,000 account, assuming the above sale, market value will be $5,200. Say X trades up to $50 and you are forced to cover the C/S at $5.00, losing the $200 premium and giving up $300 to cover the short, leaving the account valued at $4,700.

So based on the above, should:

Difference in strikes - Premium collected = VaR

???
 
The concept of VaR is a probability of an occurence, which in turn is a function of the volatility of the underlying stock, or if you prefer (I use) the implied volatility of the underlying stock's options. Also you need to determine what time frame you're going to use and with what confidence.

So if you sell the 35/40 Call spread, a typical VaR calc will throw out something like "I am 95% sure that my daily loss will not exceed $200", for example. Or "I am 90% sure my weekly loss will not exceed $350", as another example.

Personally I use 95% confidence on a daily basis, unless I'm away from my screen then I'll use the number of days away.

Do a google.
 
Quote from ogarbitrage:

... trying to compare my returns relative to the entire portfolio and relative to the amount I am putting at risk.
More...


You can keep your records in any manner that feels comfortable to you.

Even if VAR is not the correct terminology, here's what I suggest:

1) The maximum return on your portfolio is $200/$5000

The risk is $300/$5000

IMHO, those are the numbers that matter. How much do you earn in a year - that's the best way to keep score.


2) The ROI for the specific trade is $200/$300. potential profit/max risk

The risk for this specific trade is $300. In these spreads, the margin requirement always equals your maximum loss. Thus, the ratio of $300/$300 is meaningless.

Don't ignore commissions.

Mark
http://blog.mdwoptions.com/options_for_rookies/
 
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