Advanced Risk Management Techniques

Lesson eight in our free options trading course covers advanced risk management techniques in options trading which includes Delta hedging, Gamma scalping, Vega hedging, and managing options expiration risk.

Delta Hedging

Delta hedging is an advanced risk management technique used in options trading to reduce the risk of changes in the underlying stock or ETF price. It involves establishing a hedge position in the underlying stock or ETF that offsets the risk of the options position. Delta is a measure of the option’s sensitivity to changes in the price of the underlying asset.

Delta hedging works by taking a position in the underlying stock or ETF that is opposite to the options position, such that any change in the price of the underlying stock or ETF will be offset by an equal and opposite change in the options position. This means that as the price of the underlying stock or ETF changes, the options position’s delta will also change, and the hedge position can be adjusted to maintain the desired level of risk.

For example, if an options trader has a portfolio of call options on a particular stock, they can establish a delta hedge by shorting an equivalent amount of the stock. If the stock price rises, the value of the call options will also rise, but the short position in the stock will offset this increase. Conversely, if the stock price falls, the value of the call options will decrease, but the short position in the stock will offset this decrease.

If an options trader has a portfolio of put options on a particular stock, they can establish a delta hedge by buying an equivalent amount of the stock. If the stock price falls, the value of the put options will also rise, but the long position in the stock will offset this increase. Conversely, if the stock price rises, the value of the put options will decrease, but the long position in the stock will offset this decrease.

Delta hedging is an effective advanced risk management technique in options trading because it allows traders to maintain a relatively consistent level of risk regardless of changes in the underlying asset’s price. However, it is important to note that delta hedging is not a foolproof risk management strategy, and there is always the risk of unexpected events that can cause the underlying stock or ETF price to move in unexpected ways. As such, this advanced risk management technique should only be used by experienced options traders who are familiar with the risks and are able to manage their positions effectively.

Delta hedging is an advanced risk management technique that can be used to manage risk by establishing a hedge position in the stock or ETF that offsets the risk of the options position. While it is a powerful tool for options traders, it requires a deep understanding of the underlying stock or ETF and the risks involved in options trading. Therefore, options traders should always use caution when implementing advanced risk management techniques like delta hedging.

Gamma Scalping

Gamma scalping is an advanced risk management technique that is commonly used by options traders to manage and offset the decay of an options portfolio. This technique involves actively adjusting the delta of an options portfolio by buying or selling the underlying stock or ETF in response to changes in the underlying price.

To understand gamma scalping, it is important to first understand the concept of gamma. Gamma is a measure of the rate at which delta changes in response to changes in the price of the underlying stock or ETF. Options with a high gamma have a more sensitive delta, which means that their value will change rapidly as the stock price changes.

When an options trader holds a portfolio of options with a high gamma, the delta of the portfolio will change rapidly as the price of the underlying asset changes. This can be a problem because the delta of the portfolio will move away from the trader’s desired position, which can result in losses.

To offset this risk, options traders can use gamma scalping to actively adjust the delta of their portfolio by buying or selling the underlying stock or ETF in response to changes in the stock or ETF price. For example, if an options trader holds a portfolio of call options with a high gamma and the price of the underlying stock or ETF increases, the trader may sell some of the underlying stock or ETF to offset the increased delta of the portfolio. Similarly, if the price of the underlying stock or ETF decreases, the trader may buy more of the underlying stock or ETF to offset the decreased delta of the portfolio.

Gamma scalping can be a very effective risk management technique for options traders, especially those who hold portfolios with high gamma options. However, it requires active management and can be time-consuming, which means that it may not be suitable for all investors. It also requires a good understanding of gamma and its effects on the delta of an options portfolio, which is why it is considered an advanced risk management technique for options trading.

Vega Hedging

Vega hedging is an advanced risk management technique used in options trading to manage the impact of changes in implied volatility on a portfolio of options. Implied volatility is the market’s expectation of how much an underlying stock or ETF price will move in the future, and it has a significant impact on the price of options. When implied volatility increases, the price of options also increases, and when it decreases, the price of options decreases.

Vega is the measure of the sensitivity of the option price to changes in implied volatility. Vega is positive for long option positions, which means that when implied volatility increases, the value of the option increases, and when implied volatility decreases, the value of the option decreases. On the other hand, Vega is negative for short option positions, which means that when implied volatility increases, the value of the option decreases, and when implied volatility decreases, the value of the option increases.

Vega hedging is the process of adjusting a portfolio’s Vega exposure to reduce the impact of changes in implied volatility on the portfolio’s value. This is achieved by taking offsetting positions in options or other stocks or ETFs that have a different Vega exposure. For example, a trader may hold a portfolio of long call options, which have a positive Vega exposure. To hedge the portfolio’s Vega exposure, the trader can buy put options, which have a negative Vega exposure. This offsetting position will reduce the portfolio’s overall Vega exposure and mitigate the impact of changes in implied volatility on the portfolio’s value.

Vega hedging can be a complex process, and it requires a deep understanding of options pricing, volatility, and risk management. It is an advanced risk management technique that is typically used by professional traders and market makers who trade large portfolios of options. However, it can be a useful tool for any options trader who wants to manage the impact of changes in implied volatility on their portfolio’s value.

Managing Options Expiration Risk

Options trading can be a lucrative way to earn profits, but it also comes with certain risks. One of the biggest risks associated with options trading is the expiration of options contracts. Options expiration can lead to significant losses without proper risk management. Therefore, it is important to have a solid risk management plan in place to manage options expiration risk. In this lesson, we will explore different strategies and techniques for managing options expiration risk.

First, it is important to understand the basics of options expiration. Options contracts have a set expiration date, after which they are either exercised or become worthless. For example, if Betty is holding a call option contract for Microsoft stock with a strike price of $150 and an expiration date of May 1st, the option will expire on May 1st. If the stock price is below $150 on May 1st, the option will be worthless. If the stock price is above $150, the option can be exercised, allowing Betty to buy the stock at $150 per share.

However, if Betty doesn’t have enough money to exercise the option and buy 100 shares of Microsoft stock at $150 per share, she needs to sell the call option before expiration date to realize its value. This is an extremely important risk management decision for Betty, because if she fails to do so, she may get herself a margin call and her account could potentially become restricted since all stock options that are $0.01 in- the-money at expiration are exercised automatically by the OCC.

To manage options expiration risk, there are several strategies that can be employed. The simplest strategy is to close out positions prior to expiration. This is known as taking profits or cutting losses. For example, if James holds a call option contract for a stock and the stock price has risen significantly, James may want to sell the contract before expiration to lock in profits. On the other hand, if the stock price has fallen below the strike price of a call option, it may be prudent to cut losses and sell the contract before expiration if it still has some extrinsic value left.

Another risk management strategy for expiration is to roll over positions. Rolling over a position involves selling an option contract that is about to expire and buying a new contract with a later expiration date. This can be done to avoid having to exercise an option or to continue holding a position. For example, if Linda holds a call option contract with a strike price of $220 and an expiration date of May 1st, she may choose to roll over the contract by selling it and buying a new call option with a strike price of $225 and an expiration date of June 1st.

Options traders can also use hedging strategies to manage expiration risk. Hedging involves taking a position in an asset that is negatively correlated to the option position. For example, if Lucy holds a call option for a stock, she may choose to short sell the same stock to hedge her position. This can help offset losses if the stock price falls below the strike price of the call option, and if the call option expires in the money, it will be exercised, and the shares bought with the call option will be used to cover the short position.

Another common risk management technique at expiration is to use spreads. Spreads involve taking positions in multiple options contracts with different strike prices and expiration dates. This can help reduce risk by limiting potential losses while still allowing for potential profits. One type of spread that can be used to manage expiration risk is the calendar spread. This involves buying a longer-term option and selling a shorter-term option with the same strike price. This can help reduce the impact of time decay on the shorter-term option while still allowing for potential profits on the longer-term option.

Advanced Risk Managment Case Study

Albert is an experienced options trader from Seattle, Washington, who specializes in selling naked puts on the SPDR S&P 500 ETF Trust (SPY). To manage his risk, he employs a delta hedging strategy, which involves buying or selling stock to offset the risk of his options positions. Albert understands the importance of using advanced risk management techniques.

On a typical trading day, Albert sells 10 naked SPY put options with a strike price of $400 and an expiration date of one month out. Each option has a delta of -0.40, which means that if the price of SPY goes up by $1, the value of his options will decrease by $0.40. In order to delta hedge his position, Albert deploys an advanced risk management technique and buys 400 shares of SPY, which has a delta of +1.00.

One week later, the price of SPY drops by $10 to $390, causing the value of Albert’s naked put options to increase by $10 per share or $10,000 in total. However, because Albert has already bought 400 shares of SPY as a delta hedge, the value of his stock position also decreases by $10 per share or $4,000 in total. As a result, the net loss of his portfolio is only $6,000 ($10,000 from the put options minus $4,000 from the stock).

To adjust his delta hedge, Albert sells 40 shares of SPY at the current market price of $390, reducing his long stock position to 360 shares. The delta of his remaining stock position is now +0.90, which is still enough to offset the delta of his naked put options (-0.40 x 10 = -4.00). By selling a portion of his stock, Albert has locked in a profit of $4,000 on his delta hedge, which helps to offset the loss on his options position.

As the expiration date approaches, Albert continues to monitor the price of SPY and adjust his delta hedge as necessary as a part of his overall risk management strategy. If the price of SPY rises above the strike price of his naked put options, he will likely be assigned and required to buy the shares at $400 per share. However, because he has been delta hedging his position, any losses on the options will be offset by gains on the stock, resulting in a more manageable risk profile.

Albert’s use of a delta hedging strategy has helped him manage the risk of his naked put options on the SPY. By buying or selling stock to offset the delta of his options position, he is able to minimize the impact of market volatility on his portfolio. While there are still risks associated with options trading, his risk management strategy has allowed him to successfully navigate the market and generate profits.

Advanced Risk Managment Case Study II

Brittany is an experienced options trader from Studio City who specializes in selling Iron Condors on the QQQ ETF. She is well-versed in options trading strategies and advanced risk management techniques. She has developed her own risk management system to minimize losses and maximize profits. Her key risk management strategy is to roll her Iron Condor positions before expiration to capture more premium while minimizing risk.

To illustrate how Brittany executes her strategy, let’s look at a recent Iron Condor trade she made on the QQQ ETF. She sold the 355/365 call spread and the 317/307 put spread, each with a credit of $1.50. The expiration date was two weeks away, and she had a plan in place to manage the position in case the price of QQQ moved against her.

As the expiration date approached, the price of QQQ began to move higher and approached the upper strike of the call spread. Brittany monitored the position closely and decided to roll up the call spread to the 360/370 strike for a credit of $0.50. This allowed her to capture an additional $0.50 in premium while still maintaining a safe distance from the current price of QQQ.

However, the price of QQQ continued to rise, and with just a few days left until expiration, it was trading near the new upper strike. To prevent potential losses, Brittany decided to roll up the put spread as well, from the 317/307 to the 322/312 strike, for a credit of $1.20. This move allowed her to capture even more premium while also widening the distance between the current price of QQQ and her put spread.

On expiration day, the price of QQQ closed at $357.58, well above the put spread and below the call spread. As a result, both spreads expired worthless, and Brittany was able to keep the full credit she had received from selling them, a total of $3.20.

Through her Iron Condor trade and her rolling strategy, Brittany was able to manage her risk effectively while still capturing premium. She demonstrated that by rolling her spreads before expiration, she was able to adjust her position and widen her profit range, while still staying within her risk tolerance. This allowed her to generate consistent profits from her advanced options trading strategies.

Brittany’s case study is an excellent example of how to effectively sell Iron Condors on the QQQ ETF, while using rolling as an advanced risk management technique. Her ability to monitor the position and make timely adjustments allowed her to capture more premium and limit potential losses, while still generating consistent profits. This case study illustrates how using advanced options trading strategies, such as rolling, can help traders manage risk and maximize returns. it is important to reiterate that options trading involves risks and traders should always have a clear risk management plan in place.

This concludes the Advanced Risk Management Techniques lesson. Please use the menu below to navigate to the lesson of your choice.