Generally speaking, when the market goes down, volatility goes up.
The 2017 trading year provides an excellent example of this phenomenon, as the few times VIX has popped, that move has also been accompanied by a selloff in broader equity prices.
It's important that volatility traders are aware of this relationship because short premium strategies with a long delta bias are particularly exposed during a selloff.
Importantly, traders can manage their portfolios to alleviate this risk - namely by maintaining a bearish delta bias when holding significant short vega exposure.
If you'd like to review this topic in more detail, a recent episode of Options Jive is a great place to start.
On the show, the hosts walk viewers through an example that includes a range of outcomes when equity prices fall, and implied volatility rises. All the assumptions in the example remain static, except for the net delta bias.
Referring to that example, imagine a hypothetical portfolio with net vega exposure of negative 100. Now imagine that the related underlying price goes down $2, while implied volatility rises by 1 full point - certainly a plausible situation.
The chart below illustrates the P & L impact on the hypothetical portfolio given the above scenario. It also breaks down the results into three groups by tweaking the net delta of the portfolio (short delta, neutral delta, positive delta). As you’ll see, this example helps illustrate just how impacting overall delta bias (or lack thereof) is to a volatility portfolio:
As you can see in the slide above, when combined with a net long delta bias, the short premium (vega) strategy suffers when the market drops and volatility picks up. In this case, the net PnL is -$200, because the portfolio loses on both vega and delta (-$100 each).
Now compare this to the case in which the portfolio is short vega, but also net short delta against it. This time, the portfolio breaks even when the underlying price drops, and volatility rises.
It's very clear from this example that the net delta of a portfolio plays an important part in returns. It's therefore important to constantly monitor the net delta exposure of your portfolio to ensure it matches your ongoing outlook.
Depending on your own unique trading approach and risk profile, a directional bias (at times) may be the appropriate course of action. However, the risks associated with this decision should be fully accepted and understood prior to deployment.
As we can see in this example, mismanaging the delta component of a position (or overall strategy) can seriously impair the bottom line.
We hope you’ll take the time to review the entire episode of Options Jive focused on the “bearish delta bias” when your schedule allows.
This episode also highlights several other position structures that perform well with a short delta bias, in the event you are looking for new trading ideas.
We hope you’ll reach out with any questions or comments at firstname.lastname@example.org at your convenience.
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Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.