Option Market Making: Trading and Risk Analysis for the Financial and Commodity Option Markets (Wiley Finance) by Allen Jan Baird

Author:Allen Jan Baird [Baird, Allen Jan]
Language: eng
Format: mobi
Publisher: Wiley
Published: 2009-10-19T04:00:00+00:00

Figure 6.2 Implied volatility contango and backwardation of futures options.

Although time futures basis delta risk is not a serious or unlimited risk when properly hedged, the same is not necessarily true of time kappa/vega risk. The extent of backwardation in option implied volatilities cannot be fixed in advance and is theoretically unlimited (Figure 6.2). Futures options normally trade with implied volatility time spreads of only one or two points but may sometimes go out to 10 or more points, as happened in recent disorders in the stock and bond markets in 1987 and 1989.

Even if one assumes that an upward boundary of 10 or 20 points exists in the backwardation or contango of implied levels, a position with 1000 time spread contracts that experiences a kappa/vega risk of 16 cents per spread (or $80 in real dollars) will suffer an $800,000 loss in a 10-point move in implied backwardation levels. A 10- or 20-point adverse move in the time implied volatility spreads may quickly send an option trader to the bottom of the sea if he or she is not careful. Although this may not happen often, it need only happen once to end an option business.

Time strategies differ significantly in their time kappa/vega risk. Some carry large negative time kappa/vega risk, and others do not. As we noted, the short front-month/long back-month option time strategy carries negative time kappa/vega risk. Theoretically, there are 400 distinctly different two-legged time spread strategies (20 single-month positions squared). It is beyond the scope of this text to present a classification of the limits of time kappa/vega for all these strategies. Nevertheless, for those strategies that carry large time kappa/vega risk, there is no expedient way to use futures to offset this risk, as is done to hedge time delta risk. Time kappa/vega risk is inherent in any option time spread and can only be hedged, if at all, by other option time spreads.

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