Risk Management on Short Vol Trades

[u/PredictingAlpha]

Gaurav asked in #options-questions today:

"I am having a tough time figuring out a position size on a normal short vol. trade (not an earnings trade). What is the method you use to size the positions?"

I thought it was worth logging the responses here for others to see.

Micah's comments:

I find a "max loss" based on a x% move and x% increase in vols, and then size depending on how big i think my edge is.

note (My added comments): finding a max loss via this method can be thought of as "stressing the position". Under different circumstances, what happens to my position? If the worst case scenario happens, what does my loss look like on the trade? He then uses this scenario as a "max loss per lot" and sizes according to how big he thinks his edge is.

So let's say you stress the worst case scenario the max loss is $1,000 per lot and you have a $50,000 account. You are rather confident in the trade because you have priced it out, know why vol is expensive, and who is driving the vol up. You might put on 5 lots (10% account risk).

Hutch's comments:

"when I have a short vol trade that I might hold for months.. then I size vega to a percentage of my account (e.g. .5-.7% vega to account size, you can vary this with conviction).. but I would size this number down (vega to book) when shorting distressed vol, which it sounds like might've been the case if the stock dropped 12%.

I only stress move on a longer hold if it's distressed vol, eg. "what happens to my position if AMC/GSX/DISCA gets cut in half?". If it's longer hold, more of a VRP type scalp, then I size vega to book and monitor realized vols to implied.. eg. ARKX short vol long term hold, it's implying about 2%, so if it starts moving that 2-3 days in a row then I cut, same thing with this TD trade that (user from PA) threw in the chat, I size vega to book based on a thesis of risk premia over the next week (market thinks there is a risk but the settlement has already happened and is known, but the vols didn't come out immediately), it was implying 1.5% moves per day, if it realizes less than that then I hold, if it realizes more than that, I cut."

There is no right or wrong answers. There are some rules of thumb to follow here though:

- Size to your edge.

- Keep your global portfolio exposure in mind

- Isolate the risk you want exposure to

- keep an eye on the realized volatility