This post will discuss how Dr. James Schultz reviewed some key aspects of hedging a portfolio’s volatility.
Most volatility traders build portfolios comprised of both long and short premium trades across a variety of symbols. The sum of these individual positions is your "volatility portfolio."
At times, a volatility portfolio will possess a bias that can be described as flat, long, or short (in terms of premium).
Now let's look at the two main outcomes that can unfold for a portfolio facing a short premium risk profile:
Scenario 1: The market goes up, stocks go up, volatility contracts, you make money
Scenario 2: The market goes down, stocks go down, volatility expands, you lose money
If Scenario 1 unfolds, you can start browsing the internet for trips to Europe - all's good. But the purpose of today's post is to build a defense shield for Scenario 2.
By leaning our portfolio short delta (either through each individual position or using an umbrella futures product), we can insulate our portfolio from losses when the market is falling and volatility is going against us.
As "Doc" Schultz points out, maintaining short deltas in a short-premium portfolio does not mean you will always win.
In fact, if you sell volatility during a crisis period in the market, you'll often find that when the market initially rebounds, volatility tends to hold at higher levels for longer than you might expect. That means your short premium isn't paying while the short delta lean may not be feelings very good either.
However, assuming the situation is one in which a "mean reversion" does in fact occur, then over time, that short premium will contract and more than offset the short deltas you've deployed to insure against a market implosion.
The obvious next question relates to the "correct" proportion of deltas one should deploy in a short volatility portfolio. To find out the answer, tune in to future episodes of From Theory to Practice and other tastytrade programming.
In the meantime, don't hesitate to reach out with any questions or comments about hedging volatility portfolios at firstname.lastname@example.org.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.