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question on Vega and Theta

S

sarita

Guest
#1
Dear David, kindly see below:

An option portfolio exhibits high unfavorable sensetiviy to increases in implied volatility and while experiencing significant daily losses with the passage of time. Which strategy would the trader most likely employe to hedge the portfolio?

1) sell short dated options and buy long dated options
2) buy short dated options and sell long dated options
3) sell short-dated options and sell long-dated options
4) buy short-dated options and buy long-dated options.

The answer is 1.

The answer says that "such a portfolio is short vega and short theta"... would you kindly let me how you determine that and explaine why the answer is 1.

Regards,
S
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
#2
Hi Saray,

This is a tough question, IMO. First, you need to know/assume two things:
1. Vega is increasing with maturity
2. In general, Theta is negative but increasing (toward zero) with maturity

The portfolio has a negative position vega and a negative position theta; i.e.,
Greek vega = change in value/increase in volatilty. If an increase in volatility causes a decrease in value, we much have negative position vega
Greek theta = change in value/as time passes. If time passage is associated with a decrease in value, we have negative position theta
(there is an unessential interim point: Position vega = Greek per option vega * Number of options; this is how an "always positive Greek Vega" can become a negative Position Vega. For example, if you are short 100 options with Greek per option vega = +2.0, then your position vega = -100 * 2.0 = -200)

To hedge the negative (position) vega, negative (position) theta portfolio, you must:
* add positive (position) vega, and
* add positive (position) theta

Per (1) above, the way to add more positive vega is to BUY long-dated options (selling options will add negative position vega and cannot be correct; with regard to vega we can eliminate answers #2 and #3 because they both reduce our negative vega, so they go in the wrong direction)

Per (2) above, the only way to add positive theta is to SELL (go short) with near-dated options (with respect to theta, we can eliminate #4 and #2)

Hope that helps, tough question.... thanks, David
 
#3
An option portfolio exhibits high unfavorable sensitivity to increases in implied volatility and while experiencing significant daily losses with the passage of time. Which strategy would the trader most likely employ to hedge his portfolio?
Choose one answer.
a. Sell short-dated options and buy long-dated options Correct
b. Buy short-dated options and sell long-dated options Incorrect
c. Sell short-dated options and sell long-dated options Incorrect
d. Buy short-dated options and buy long-dated options Incorrect
The correct answer is Sell short-dated options and buy long-dated options.
You are short gamma and long theta, and this calendar spread will create a good hedge for you

Can any one explain the answer little more i thought implied volatility means vega?.
Why are we going long theta
 

ShaktiRathore

Well-Known Member
Subscriber
#4
The market seems to have bottom out because when the market is bottoming out the relation of vega with the option price becomes negative. Because as the implied volatility becomes high as the markets goes bottom any increase in volatility(IV) will only decrease the price of the option as stock trends downwards more thereby decreasing the price of the call option. So increases in IV is resulting in unfavorable sensitivity of option portfolio to IV and there are losses with passage of time. So trader should short the short dated options so that trader faces long (positive senstivity to volatility)positive vega poistion when market is at bottom in short term but as markets comes to mean level over long term the price volatility relation turns back to normal that is a positive relationship. So trader has sell short-dated options(hedge negative effect of vega).
for more visit: http://www.investopedia.com/university/option-greeks/greeks3.asp
thanks
 
#5
Hi
But a long position whether buy or sell adds to the negative position of vega on portfolio as vega increases with long positions how did it in this case add a positive position i can't understand !!
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
#6
Hi @suhaabughosh you might need to be more specific about to what above you are referring but the original question assumes a position that has negative position vega (as would have the writer/seller of option who loses when volatility increases; lately there has been much press about this profitable short volatility traders who are making money because volatility is low. They are negative position vega!). To neutralize or mitigate negative position vega (which itself can be created by writing either calls or pus), you can purchase calls or puts (long options have positive position vega). In choice (1), there is a sell and a buy, but the buy is long-term so the net position vega of the trade will be positive position vega, to hedge/mitigate the underlying negative position vega. Thanks,
 
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