In traditional portfolio management, the investor will spread positions across different asset classes, stock sectors, or market cap to avoid a single event bringing down the entire portfolio. With options trading, we can diversify in similar ways, but we’re exposed to another variable that most stock traders aren’t: volatility. As volatility traders we’re exposed to volatility risk on purpose. We can diversify a volatility portfolio in four main ways: across assets, across time, across strikes, and across strategies. Concentrating trades in one asset class exposes us to macro events in that area and choosing only certain types of strikes and strategies can bring in new types of risk, such as gamma. But what about diversifying across time? To illustrate, let’s take a look at the term structure of volatility futures:
This is a fairly typical vol term structure, where the near term volatility future is trading lower than farther term futures (contango). This intuitively should make sense, as we are more uncertain about the market a year from now as we are a month from now. Sometimes, though, a market-shaking event can occur that causes front month vol to spike and the term structure to enter backwardation. If all of our trades are in one month, that’s where all of our vega risk is, and our entire portfolio is exposed to these types of events.
Where the portfolio currently stands, we’re using around half of our available buying power, all of which is in January options. While we’re fairly diverse in our asset classes (bonds, consumer goods, gold, and small-caps), strikes, and to a lesser extent strategies, I think we’ve got more than enough risk in January. Moving forward, we’ll look to place trades in a different expiration, as well as keep an eye out for long vega trades since all of our current trades are short vega.
Vega Medic 