Tutorial #3 – Option market making : start learning to manage option risk in Volcube
As soon as you have traded during a Volcube game, you will have acquired risk. The risk for the buyer or seller of any asset, whether they are options or works of fine art, is that their value in the market will alter. If you buy some options, your primary risk is that their value falls. If you sell options short, your risk is that their value might rise.
With options, there are several different factors that can affect their value. So we need to keep track of these factors and the implications for the value of our options portfolio if one of these factors changes. The best-known option risk management tools are the option Greeks. You will learn more about these as you play and study on Volcube.
Let’s consider the different risk management tools at your disposal during a Volcube game. Again, if you haven’t watched Quick Start video #2 – A tour of the Main Game, either now or at the end of this tutorial would be a good time.
In the top left of the Main Game screen is our TradeLog. The most basic risk management tool is an audit trail of our trades. The TradeLog displays our option and spot trades as they occur.
In the bottom left of the Main Game screen is our inventory. Our inventory is sum of all our trades displayed on per strike basis. So, if we buy 200 of the 97 calls and later sell 150 back to the broker, our inventory will show us long 50 lots of the calls. The inventory can be viewed either with calls and puts separately or as a net figure showing our call and put position combined per strike. You will learn later that because put-call parity holds in Volcube, we can consider calls and puts of the same strike as essentially the same options, for risk management purposes. For now, just understand what you inventory displays. It displays our current position.
In the bottom middle of the Main Game screen is the Risk Detail. The Risk Detail shows us the value of the Greeks (just think of them as measures of option risk for now ) associated with our portfolio for different prices in the spot product. What does this mean? If you look at the middle column in the Risk Detail, this will display our Greeks given where the underlying product is currently trading. If you look right or left, it will show how our Greeks will alter if the spot product price rallies or falls. Some other things to note in the Risk Detail: the bottom row displays our theoretical profit and loss, for differing spot prices. So our current profit and loss versus the current spot price is the number in the centre of the Theo P&L row. Also notice the Volcube Risk Metric (VRM) in the bottom right of the Risk Detail. This gives you a snapshot in one number of your entire risk. It can be a useful guide when you are just starting out on Volcube and before you fully understand how to manage option risk on a Greek-by-Greek basis. One final point; the TPI indicator in the bottom left of the Risk Detail. The colour of the TPI indicator will be green when your current game qualifies for a Trading Performance Index. Amber means the game could still qualify for a TPI. Red means the game cannot qualify (most likely because Market Mentor has been used).
In the bottom right is the Risk Limit pane. This indicates how our Volcube risk manager views our risk relative to the automatically-generated risk limits. The traffic lights and percentage numbers will give you an indication of which of the five segments of your risk are problematic. The meaning of these numbers will become clearer and you play on Volcube and Blitz Video #4 – Trading within Risk Limits will help you in this regard.
Now you know your way around, how should you start to learn option risk management techniques in Volcube? The best way is to start trading, which will generate some risk. Then see if you can make sense of the numbers. Make sure the inventory matches what you expect given the trades in your TradeLog. Once you have read some of the Learning environment material and watched the videos on the various option Greeks, start to piece together why certain trades seem to have certain risk profiles. You should notice that if you buy options, you will become long vega and gamma, whereas selling options makes you short vega and gamma. On the Pricing Sheet, you can see the Vega and Gamma and Theta for each option (using the green arrows in the Vega column header). Multiplying these numbers by the quantity of each option traded should lead you to the numbers in the Risk Detail central column. Of course, you will need to know what these numbers actually mean, and you can learn this from the Learning environment and also by using the Market Mentor. Market Mentor (see the later tutorial for full details) will also help you to start to interpret the risk numbers and be able to account for them in your future trading.
What is the goal of option risk management?
In Volcube, we look to make a profit by buying options on the bid price and selling the same or similar options at higher asking prices (in volatility terms – see later tutorials), capturing the bid-ask spread to the greatest extent possible. The skill of risk managing the option portfolio is to ensure that in the intervening period between selling and buying options, the portfolio does not incur losses that negate the profits made from trading on the bid-ask spread.
The basic ideas around option risk management are fully transferable to other styles of option trading. Whether market making or trading volatility in a speculative or proprietary fashion, managing an options portfolio by fully understanding the Greeks, and how they alter, is at the heart of all option trading strategies.