The Lifecycle of a Vega Options Trade

I’m just a student of Paul’s Vega Option’s method. But as I see it, the Vega Options strategy has three steps:

1. Taking directional trades using creative options structures optimized to volatility that create highly leveraged bets as a way to control risk.
2. Hedging profitable positions to remove original risk, lock in profit, and transform the position from a delta-driven trade to a theta-driven trade.
3. Combining two or more hedged positions to create the widest possible zone of profit, allowing you to hold positions closer into expiration and maximize returns on theta.

One of the keys to successfully trading this strategy is understanding where your current portfolio is in this three-step process, so that you can have a clear understanding of what is driving your trade. Each step has different priorities and requires a different thought process.

Step 1 is classic directional trading. We put our own spin on it, but fundamentally we initiate positions based on the direction that our technical analysis tells us the underlying is most likely to go and where it is likely to end up by a certain time.

Step 2 is focused on reducing risk. Our directional thesis has proven correct, and the trade is working. What is the simplest and fastest hedge available to lock in our profit and remove our original risk from the position? This step is influenced by our technical analysis, but it isn’t necessarily driven by it. In other words, we try to choose a hedge that reflects our directional bias, but the priority is getting the hedge on to reduce risk.

Step 3 is all about assembling multiple hedged positions to create an expiration graph that provides a true “non-directional trade.” This step isn’t motivated by where we think the underlying will go; rather, it’s motivated by where we think the underlying might go, and trying to make sure that we have all of the reasonably likely outcomes covered.

Let’s use this position, from Paul, as an example:

First of all, nice position! The Nov 11 expiration graph has a zone of profit well over 500 points wide! Let’s look at how Paul got to this position, and what he might want to do next.

This position is made up of three separate structures:

1. a Nov11/Nov14 3600 put calendar
2. a Nov 11/Nov14 4000 call calendar
3. a Dec 30 4000/4100/4200/4300 call condor

I’m guessing that Paul hedged or legged his way into each of these three positions. The calendars probably started as diagonals, and the condor probably started as straight calls or as call verticals. The Put Calendar now only has about $4 of original risk per unit. The Call Calendar now has no original risk at all! And that massive call condor now has only about $10 of original risk per unit!!

So for these three trades, Steps 1 and 2 are complete. But let’s look at the overall position and Step 3. It’s pretty clear that Paul has a bullish bias, and if $SPX continues to drift upward, this position will do great. But what if Paul’s directional bias doesn’t pan out? (Unheard of, I know). We have a strongly positive delta, so any move lower is going to hurt open profit (we’re setting vega aside for now). And if $SPX were to close in the 3750-3800 area on November 11, the position could lose half of its open profit.

So what should Paul do to reduce that risk? Regardless of his actual directional bias, he should look for an opportunity to initiate a bearish trade targeting that 3800 area–something like a Nov14/Nov11 3850/3800 put diagonal. Even if the overall trend is up, Paul can use a minor retracement, even an intraday retracement, to hedge the original risk out of that diagonal, leaving him with put calendar that will act as a risk-free hedge for his overall position. As long as the location, expiry, and sizing of the position are correct, that put calendar will lift up the big dip in the expiration graph and also flatten the deltas through that 3800 area.

Here’s the opening position:

And here’s what it would look like after a “zero-cost” hedge:

That’s not bad. We now have a nice, third max-profit peak at 3800, and the negative deltas of our T+0 line have been tamed a bit. But we still have a big dip in the expiry graph around 3700.

I know Paul likes wide diagonals. so what happens if we move the short strike on this diagonal down to 3750, making the opening diagonal 100-points wide? Here’s the opening position:

And here it is hedged:

Interesting! Now we’ve lifted the lower dip significantly, but we’ve also deepened the upper dip by a bit. The options are endless. (See what I did there?) The point is that the decisions driving trades in this Step 3 have more to do with customizing your risk graph to a desired result than they do with where you think the underlying is most likely to land.

Play around with these positions, and perhaps you can find an even better solution than I did. Experiment with different structures, locations, expiries, and sizes. Observing what a change in each of those variables does for your expiration graph and your T+0 line will deepen your understanding of options mechanics and the inner workings of the Vega options method.

Questions?