Learning to reduce an options portfolio to its essential components
Options trading skills tested :
Options portfolio management skills. Understanding vega buckets.
How to set up the training exercise
Load any Volcube simulation and make a few quotes and execute some trades against the broker in a number of different strikes so that you have long and short net option positions across the curve.
Option positions can become highly complex. They can involve longs and shorts across a range of strikes, across different calls and puts. When an experienced trader looks at such an inventory, he or she will be able to ‘reduce’ the position down into its essential components. This is achieved by stripping out tight spreads whose vega and other Greeks are reasonably low-impact on aggregate. It can also involve averaging vega across strikes, weighted by the number of lots in the position. The trader is usually aiming to distill his or her position into something that can be described in a sentence. So although the inventory might involve longs and shorts over 20 different strikes, the trader may be able to say that “Basically, this position boils down to being long a call spread and short a put spread”. The trader does not mean this is literally all there is; he means that the essential risk of the position resembles that of a long call spread versus a short put spread. Another way to understand this is to say that if the trader sold an appropriate call spread and bought an appropriate put spread the overwhelming majority of his option risk would be mitigated.
The technique you will learn through this exercise is described in detail here : http://www.volcube.com/resources/options-articles/simplifying-option-vega-spreads/
Create a complex position and practise reducing it down with pen and paper initially. You will test your results using the in-game Volcube Market Mentor. Do not worry about achieving the precise result Market Mentor returns. There is more than one way to distill a position although most will reduce to something similar. When you feel you have reduced the position as much as is sensible, try to summarise it in a sentence. “I am long some puts, short some at-the-monies and then short a call spread.” or some such. Remember you can usually only reduce a position so far. Strikes that are too far apart cannot usually be considered tight spreads and therefore may not sensibly be stripped out. One indicator as to how much reduction is possible is your Volcube Risk Metric (VRM, visible in the Risk Detail). If this number is very low (<50 say), then your overall risk is low; if you have lots of inventory in that case, it is likely that a lot of simplication will be possible. But if your inventory is sparse and small when your VRM is low, it suggests the position is just small and unlikely to be highly reducible. Really this is about reducing your inventory down into vega buckets. These are pockets of options with similar properties (i.e. typically with their strikes are close together) that the experienced volatility will look on as so similar that they can be bucketed together. And if there are longs or shorts in such buckets, these spreads may be eliminated altogether, for the purpose of boiling the position down to its essentials.
This exercise will teach you a vital skill about managing large options inventory in Volcube and a skill used by experienced option traders in real life.
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Volcube : options training technology
The world's most advanced option market simulator and training tool, used by leading derivatives trading firms to train their option traders.