Understanding Higher Order Greeks
Managing your option Greeks is essential to every option trader, especially to a portfolio manager. Most option traders are limited to managing the Greek Delta only. However, in order to trade options safely, you must know how to manage your Delta, your Vega and your Theta on a deep level and this requires knowledge of higher order Greeks.
There is a grand misconception in the industry. Traders think they can manage their Greeks simply by balancing their Delta position; however, this thinking process is a mistake. Your option Greeks such as Delta, Vega, Theta and Gamma are managed by higher order Greeks. They are not managed by neutralizing Delta.
Let us give you an example of managing your first-order Greeks with higher order Greeks so you can understand why this is such an important concept to grasp.
MANAGING VEGA WITH VOMMA & VANNA
Typically, but not always, as an underlying falls in price, its volatility increases. This inverse correlation is extremely strong and consistent. With larger drops in price, the inverse-correlation probability increases. One of the most common mistakes that option traders make is to deploy negative Vega and negative Vomma option strategies as the underlying product is dropping in price. This puts their portfolio at tremendous risk. This accounts for many if not most account blowups across brokerage accounts worldwide. There is a serious lack of understanding of price to volatility correlations as well as how to manage the Vega of an options portfolio.
Bearish strategies should be designed with positive Vega and positive Vomma. They should not be designed with negative Vega or negative Vomma, which is what most option traders are doing. Some of the bearish trades that are negative Vega include put broken wing butterflies, uncovered puts, short strangles, short straddles, covered calls, bull put spreads and iron condors. Although these strategies are very popular, their Vega positions are designed to lose money when volatility increases, and volatility consistently goes up when the price drops. Therefore, these are not well designed options strategies.
One positive Vomma bearish trade is the back ratio. Although not my favorite trade, this can be used as a hedge or as a stand alone method for bearish moves. This will give you positive Vega and Vomma, so it can profit in a bearish market and it will also clean up if there is a flash crash.
Vanna is also key to managing Vega. A -Vanna will keep Vega positive as the underlying drops in price. This has obvious benefits, but most traders are trading with +Vanna, which is detrimental to their portfolios.
MANAGING DELTA WITH GAMMA & CHARM
Delta can be managed with the higher order Greeks known as gamma and charm. Most traders have heard of the gamma, but these traders do not know how to make it flat. They typically trade with a very strong negative gamma which causes their Delta to change unfavorably against them very fast.
Charm is another fantastic higher order Greek to master. This Greek describes how your Delta will change through the passage of time. For example, you can design a bullish strategy that will dynamically increase its own Delta position by the minute. As the product gradually increases in price, + Charm continues to adjust the position Delta in a favorable and profitable way. You can use a negative Charm for bearish strategies.
If you want to manage money for others using options, then you must understand how to manage your Greeks. This is only done by managing higher order Greeks. Vega is managed by Vomma and Vanna. Delta is managed by Gamma and Charm.
We’ve been using higher order Greeks since 2009. Let us show you how it’s done. We can keep you and your clients safe and profitable. As always, best of luck with your trading, and we hope to see you in class soon!