Make Vega Your Friend

An In Depth Conversation With a Portfolio Manager

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by Gavin in Blog
February 25, 2014 12 comments

Below is a conversation I had with a friend of mine who is a portfolio manager. Some very interesting takeaways on how to protect a portfolio of stocks and “Make Vega Your Friend”.

Let’s do a recap of the conversation and then readers can ask questions in the comments below:

GM: How do you protect a portfolio of equities? 

HA: The key is I like to alter my duration depending on the general vol environment and VIX.  For example with VIX under 14 I would go to a 3 to 6 month duration at the 5-10% out of the money level.  So as of yesterday I would be long October Spy puts, beta weighted to cover my notional stock exposure, at about the 166 strike (if my portfolio is a .75 beta to the SPY then I would have enough puts to cover at least 75% of notional – remember things become more correlated in a selloff so err on the side of more puts).  With VIX at 12 I would go 12 months out.  Why? It’s all about Vega- when vol is low I want to own Vega.  With VIX at 18 I would bring the duration in to 2-3 months and anything above 20 it would be very near term puts because when things get crazy I want to own gamma and not Vega.   The ability to alter duration gives me lots of control. Let’s examine:

Let’s say I have Sep on right now with SPY where it is. If we get another selloff and come down 6% VIX will likely be 18 or 20 and I will not only outperform the SPY with my puts but also get an extra kick from my Vega exposure.  Those Seps will explode in value and I will make much more than I  might have expected with the vol jump.  Then what can I do? I need to reduce my Vega exposure – I don’t want to hold VIX at 20.

I want to own gamma at this point.  Realized movement is likely to continue with VIX up there, VIX futures are likely backwardated, so I want my protection to be all gamma and really kick in if I need it so I roll Sept to March.   I will do this for a large net credit so I essentially have scalped Vega and put money in my pocket and kept the same protection, same number of contracts.   Or what I can do is add a few put contracts at the new duration and turbo charge my protection should things continue down.  Vols are very high so I can also try to  add some alpha by selling some upside calls for yield, or add a frontpread to take advantage of upside skew and create a kicker to the upside (add a 1×2 calls spread for hopefully a credit).  Or simply use the cash to buy some more of the underlying portfolio.

But now that I’ve replaced my long term puts with short term I have less to lose if we rally back, still have a little vega but mostly lots of gamma to the downside.  This is how a market reset can really put you in the outperformance drivers seat versus everyone else.  I was asked to help out with a fund that has put protect strategies like this and they weren’t using Vega to their advantage and could have done much better near the lows in 2008.  They kept a portion of their long term puts at a long duration and gave back so much as vol came off and the market started to rally.  It’s all about moving from Vega to gamma and back.  Make Vega your Friend – that is using volatility to your advantage.

This might be a duration table for this protection:

VIX at 11-13 = 6 to 12 months out

VIX at 14-16 = 3-6 months out

VIX at 17-20 <3 months

VIX at 21+ < 2 months

Other things to look for. Is downside SPY skew flatter than usual? That can happen after giant persistent rallies – backspread it as a swan catcher type trade.
A more sophisticated VXX/SPY swan catcher – own SPY puts and hedge the vega with long VXX put spreads.  When vol is really low this is a nice swan catcher that you can put on for almost no cost.
vol trading made easy

GM: A couple of follow up questions:

1. In the example you have, you are outperforming the SPY in the event of a selloff, but what if the market rallies? Your puts will get crushed.2. Can you explain this in more detail? “or add a frontspread to take advantage of upside skew and create a kicker to the upside (add a 1×2 calls spread for hopefully a credit).”3. Can you give an example of how you would Make Vega You Friend? Let’s say you have $100,000 in SPY. Where would you buy puts and how many contracts.


1)  We don’t mind if the market rallied because we’ve moved our exposure to a shorter duration and thereby scalped Vega. – then we have less at risk.  I actually did this in a portfolio recently.  Let me illustrate.  At 184.15 I rolled my March 160 puts into June 165.  VIX was very very low and that was the green light for me to move to a farther out month.  Remember, when the VIX is low I want Vega exposure-that means going farther out.   VIX rarely goes below 11 but it frequently goes into the high teens.  You want Vega because not only will your puts kick in but you will be better exposed to a rise in implied vol the farther out you go.  At VIX 11 I would be going out 12 months at least.  So yes on the rally I took a hit on my March 160 puts, which I owned against SPY since October, but the SPY moved up so I was fine with it.  I pocketed money for moving my duration in. I didn’t make 100% of the SPY move back to 184 (only about 85%) but that is the price of insurance.  So I moved into the June 165 puts (a closer strike because SPY had moved up from my initial hedge and I want my puts about 10-13% lower).  Then we had the little market selloff and at 175 my puts were worth about $22,500, about $9,900 more than where I bought them.

Recall that VIX went to 21 so a good chunk of that came from vol going up and not just the gamma exposure from my puts.  That’s why I want Vega exposure.  Now, at VIX 20 I don’t want to own Vega any more so I roll in to March 165 at 1.25 from the June at 4.38.  So I have the same number of puts and coverage for my portfolio but I don’t own them for as much.  Yes it’s true that the March were bought at a high vol – it doesn’t matter,  I want to own gamma because the market is moving a lot – we were either going down another 10 or up 10. The VIX futures curve was denoting a bit of panic when it backwardated (higher front month than second/third etc.).

Now, the fun thing I can do here is buy some extra puts with the ‘free’ money I made.  I can buy 20% extra puts for only 25% of the money I made.  Now if the market tanks I actually have better protection in a crash ( 120 puts instead of only 100 to cover my 10,000 shares).   I have leverage!  But you don’t have to do that.

The great thing about this strategy is you’re always covered for a swan-like downturn.  You never actually get rid of your puts, you merely move them in and out depending on where vol is.   If someone is tempted to sell out their protection and time the market they are just taking shots, which often don’t work out.

In 2008-2009 I’m sure we all would have been tempted to get rid of our puts at some point but it would have been wrong all the way down 50%!   Now, of course once the market starts to go through your put strikes you also have to move the strike down.   Once the puts are deep in the money you’re leaving too much risk on the protection in case the market bounces.

2)  One of the ways I try to finance my puts is by selling calls on the SPY when it looks toppy or even when vols are popping.   What you can do when skew gets steep to the upside (outer calls are expensive relative to the ATM, which I try to monitor most days) I do a 1×2 frontspread.   So buy one 185 and sell two 187’s for example.   If the 187’s are a little expensive then I can perhaps do the package for a credit or even money.   Then if the SPY closes above 187 at expiry I get called away on 2 calls and I’m ok with it because I was trying to covered write some stock anyways.  But if it goes to 186.50 I’ve made a $1.50 kicker for my portfolio.  Yay!  Only do these for a net credit or even money, never for a debit.

3) Right now with 100K, that is about 540 shares of SPY, so I would pick up 5 or 6 June 165 or 167 Puts.  I would move that out to Sep if the VIX gets below 13.   If I had a mishmash of single stock positions I would beta weight it (Think or Swim) can do that.  Then if the beta is .75 to SPY you only need  three quarters the number of puts.  Roughly.

Now, if the market drops I wouldn’t do much with my Vega exposure until the market is down about 4-5%.  Then move it in.  If the market goes up 5% I would move the puts up 5%.  That kind of thing.

A trader might wonder why vols get cheap or expensive. Same as equities – supply and demand! When I was primarily a long gamma trader (for most of my career), meaning long options and trading the ‘bend’, I sometimes wondered why people smashed vols down to ridiculous levels. Now that I’m on the opposite side, the overwrite business, I understand it. Funds like mine are mandated to sell calls against their holdings, regardless of vol level. Some funds have more discretion, ie they will only sell ‘rich’ implied vols and won’t sell the cheaper ones, but funds like mine have to sell them all. In Canada, where liquidity isn’t that great, this creates an options market that is skewed to the downside because the market makers know that most of the flow will be hitting the bid. They keep the option bids low so that they can buy them cheaply.

Another thing newbies need to know is synthetics – they are incredibly important and something that I always teach traders.
long 1 call and short 100 shares of stock= long 1 put (let’s forget about dividends and interest for now)
short 1 calls and long 100 shares of stock= short 1 put

If I ask someone, are you comfortable being short a naked put? most will say no of course not! but if I say, are you happy being long a covered write (long stock short calls) they say sure. that doesn’t make sense because those are the exact same positions from a risk standpoint. plug them into any position graphing software and see. Folks need to understand synthetics better. It helps to understand why a market maker loves to buy cheap calls at the top. I used to love doing that because I would sell stock against them on a delta and turn a significant portion into synthetic puts. i.e. I buy 100 at the money calls and sell 5000 shares of stock. now I have 50 calls and 50 synthetic puts (long 50 calls and short 5000 shares= long 50 synth puts) – now the position is a straddle, long 50 calls and long 50 puts!

GM: Also, you mentioned the VXX/SPY Swan catcher. Can you explain more  about that and give a current example?

Right now if I had 500 shares of SPY, I could buy 5 10% out of the money puts in June.  Let’s say 167 puts.   Those are going to cost me as time goes on in the form of theta (and perhaps in Vega if the vol on them drops).  What I can do to hedge that Vega is buy VXX puts and attempt to put on the protection for close to free.   VXX is a product that erodes over time because 85% of the time the VIX futures curve is in a contango and the product sells cheap futures and buy more expensive ones on a daily basis.  So currently the futures are in a bit of a contango, but could be a much more curved one.  So we are going to benefit from the roll yield that I mentioned.  As well, the VIX cash is usually below the futures, as it is now, and the two have to converge by VIX expiry.  So it is likely that VXX will also go down because of that.  So we need to try to cover the vega on the spy puts that we bought with VXX puts or put spreads.  when vol is cheap on VXX we buy straight up puts, when more expensive we will buy put spreads.  When extremely expensive we might sell VXX call spreads.  So if the Vega on your SPY puts is let’s say 200, you need to hedge out 200 by buying a short VXX position that is short 200 deltas.  For every downtick in SPY vol VXX should go down $1 – therefore -200 VXX deltas will cover +200 vega in SPY. Plus you’re going to get the roll yield.  All else being equal VXX MUST go down over the long run with futures in a contango.  Look at the VXX chart over the last 5 years – it has lost 98% of its value.  The person who created it has even said that it is meant to go to zero, but they keep consolidating it when it gets too low.

  1. Stephen says:

    Brilliant article! This truly demonstrates the need to know your options and how ALL the Greeks relate. Synthetics are so neglected in almost all options education I’ve run across. I think hedging with SPY puts and constantly rolling them up or down can be effective for non-directional traders as well esp in a low vol environment. The recent sell-off (and Vol explosion) did major damage to any Iron Condor or Bearish Butterfly…would SPY protection have helped to stay in for the eventual bounce? I believe your respondent mentioned gamma scalping…can you speak to this as well?

    1. Hi Steven, I did a case study on gamma scalping that you can check out here:

      Here is some further information on gamma:

  2. Mike says:

    Great article and insight! Thanks for posting.

    1. Thanks Mike, glad you enjoyed it

  3. Paulo says:

    Awesome! This is the kind of stuff we want to read!

    1. Thanks for the feedback Paulo. Glad you enjoyed the article.

  4. stevengabriel says:

    I love this–this is how I trade as well. Over time, I’ve learned that we can predict vol better than we can predict underlying movements. In essence, the structure is more important than the underlying that you pick. You are, in a way, setting yourself up so that you can get lucky. Heads you win, tails-you don’t lose much.

    Is there any way to make contact with your friend through email?

    steven gabriel

    1. Hi Steven,

      Thanks for stopping by my site, I’m honoured. Email me at [email protected] and I will get you in touch.

      I don’t want to post his email here for privacy reasons.


  5. theta1 says:

    “For every downtick in SPY vol VXX should go down $1 – therefore -200 VXX deltas will cover +200 vega in SPY”

    For every downtick in SPY vol of which maturity? 1m, 3m, 1y? And if (or when) VXX goes down by 50%, will it still be $1 of VXX = 1 vol point of SPY? You can see that this simplistic approach is not right. If it happens to be the case for a given vega level/maturity/spot level of SPY and dollar value of VXX (after or before a reverse split for example) it would be a coincidence that wouldn’t last long. I would like to see what the actual relationship is between %age move of VXX is and SPY vega.

  6. Mel says:

    Gav, great article. I am making this Hedge work right now and it is easily financed through the sale of shorter expiration puts. I put it on at SPY = $194.68 and VIX = 11.82. Bought the beta weighted number of June, 2015 185 puts. I have consistently sold July, August and September puts on these pathetic down days in the SPY. Waiting for my first chance to roll in with a VIX pop, but so far have not seen any since 6/11/2014 my start date for the hedge.

    VXX Black Swan catcher is unclear for what duration the puts should be purchased. Is your friend saying buy the front month VXX put ATM? Would be great to have the VIX levels guidance for buying the VXX puts. He said how he would buy them and finance them based on VIX level, he just never said which month he was buying or selling based on volatility. I await that information before adding the VXX trades as another hedge strategy on my hedge. Are you thinking about a Part II for this post?

  7. Gavin says:

    Hi Mel,

    Glad to hear the strategy is working out well for you!! How did you go this week on the 2 down days?

    I’ll see if I can get my friend to do a follow up.

  8. Steve W says:

    Wow! This may be one of the most interesting articles I have ever read on option trading! There is so much information, I will have to read it several times.

    I’m just wondering if there has been any progress on doing an update? I am also wondering how this strategy could be used if holding ZIV or SVXY instead of SPY. For one thing, I’m assuming more puts would be needed, since those have a beta larger than SPY?


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