flexible enough to tailor a position around a forecast. It’s about minimizing
the unwanted risks and optimizing exposure to the intended risks. Still,
there always exists a trade-off in that where there is the potential for profit,
there is the possibility of loss—you can always be wrong.
Recalling the at-expiration diagram and examining the greeks, the best-
case scenario is intuitive: the stock at $75 at expiration. The biggest theta
would be right at that strike. But that strike price is also the center of the
biggest negative gamma. It is important to guard against upward movement
into negative delta territory, as well as movement lower where the position
has a slightly positive delta. Exhibit 16.6 shows what happens to the greeks
of this trade as the stock price moves.
EXHIBIT 16.6 Ratio vertical spread at various prices for the underlying.
As the stock begins to rise from $71 a share, negative deltas grow fast in
the short term. Careful trend monitoring is necessary to guard against a
rally. The key, however, is not in knowing what will happen but in skillfully
hedging against the unknown. The talented option trader is a disciplined
risk manager, not a clairvoyant.
One of the risks that the trader willingly accepted when placing this trade
was short gamma. But when the stock moves and deltas are created,
decisions have to be made. Did the catalyst(s)—if any—that contributed to
the rise in stock price change the outlook for volatility? If not, the decision
is simply whether or not to hedge by buying stock. However, if it appears
that volatility is on the rise, it is not just a delta decision. A trader may
consider buying some of the short options back to reduce volatility
exposure.
In this example, if the stock rises and it’s feared that volatility may
increase, a good choice may be to buy back some of the short 75-strike
calls. This has the advantage of reducing delta (buy enough deltas to flatten