Options Q&A: How do I hedge against volatility risk?

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Implied volatility is one of the most important factors in options pricing, and traders need to understand exactly how much that volatility is affecting the price of the option they are looking to buy or sell, as there is a great deal of risk associated with future changes in volatility.

Once implied volatility is taken into account, however, it is possible to shape options strategies to downplay the volatility risk.

The way an option's price reacts to changes in volatility is called vega.  This is given as a number between zero and one, indicating the amount the price of an option will change for every 1% change in implied volatility of the option.

So an option with a vega of 0.5 will see its price rise $0.50 if volatility of the option rises by 1%.  On the other hand, this option will see its price fall $0.50 if volatility drops 1%.

Vega for both calls and puts is positive.  This is different from delta, for example, which measures how the price of an option changes when the price of the underlying asset changes.  Delta has a negative value for puts and a positive value for calls.  In order to create a delta neutral strategy, a combination of puts and calls can be used.  It is also possible to hedge delta using a position in the underlying asset.  For instance, going long a stock, but hedging by buying a put on that same stock.

This isn't possible when attempting to hedge volatility risk.  Since vega is positive for both calls and puts, it is necessary to hedge vega using a combination of long and short positions.  Also, it isn't possible to use a position in the underlying asset.  Other option positions must be used to create a vega neutral strategy.

To hedge vega, it is necessary to use some combination of buying and selling puts or calls.  As such, a good way to limit the volatility risk is by using spreads.

There is a wide variety of spread strategies.  The main attribute of the technique is to combine long and short option positions for the same underlying asset.  These can be done using different strike prices or different expiration dates, depending on how the investor is looking to profit from the trade.  However, the fundamental aspect of the spread position is that it involves simultaneously buying and selling certain options.  This can involve either all puts or all calls, or a combination of the two, depending on the structure used. 

An example of a relatively simple spread would be a Bull Call Spread, which involves buying calls at a certain strike price, and simultaneously selling the same number of calls at a higher strike price.  There are more complicated spread strategies as well, some involving a combination of calls and puts.  Examples of these would include Iron Butterflies and Iron Condors.

For all of these, the fact that the strategy involves the simultaneous long and short positions leads to offsetting vega. Whether or not they are completely vega neutral will depend on the structure.  But using spreads will limit the volatility risk in the trade.

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