Volatility Trading 101 — What are the greeks and how can be used for hedging the Theta Vault?

Last month we published a medium article about volatility trading, basic terms of volatility trading, and different kinds of strategies that can be used to trade volatility.

Today, we will describe what are the “Greeks” letters in options trading and how to use them in order to create the best strategies to protect liquidity in the Theta vault.

What are the “Greeks” in options trading?

The “Greeks” are a set of measures used in options trading to analyze the risks and potential rewards of a particular options position. These measures are used to understand how the price of an option might change in response to various factors such as changes in the price of the underlying asset, changes in volatility, time decay, and interest rates.

There are several different Greeks that are commonly used in options trading, including:

Delta: Measures the degree to which an option’s price will move in response to changes in the price of the underlying asset.

Gamma: This measures the rate at which an option’s delta will change in response to changes in the price of the underlying asset.

Theta: This measures the rate at which an option’s price will decrease over time due to the passage of time and the resulting decline in the option’s time value.

Vega: This measures the degree to which an option’s price will change in response to changes in the implied volatility of the underlying asset.

Rho: This measures the degree to which an option’s price will change in response to changes in interest rates.

How can we use the “Greeks” to hedge the Theta Vault LPs?

First, Let’s describe the Theta Vault LP’s exposure. As the vault acts as a structured product that in essence sells volatility, the hedging will involve a LONG volatility position.

The exposure calculation (Max drawdown)

D — User’s deposit to the vault

TD — Total deposits to the vault

C — Total $CVI open positions (excluding those owned by the vault)

CVI — CVI Index

Amount to hedge = D / TD * (200 / CVI — 1) * C

Example:
- The user deposits $100,000 to the vault

- Total deposits are $10,000,000

- CVI index is at 100
- $CVI open positions $300,000 (Total minted/bought on the DEX = 3000 $CVI)

Amount to hedge = 100,000/10,000,000 * (200/100–1) * 300,000 = $3000

The strategies — Long volatility

Hedging volatility we need to buy Delta-neutral Vega-long positions. There are 2 simple combinations with these characteristics:

1. Long Straddle
2. Long Strangle

The general goal is to build a combination neutral to both price changes and implied volatility changes, allowing a liquidity provider to gain profits from the funding fee with minimized risks.

Ideally, the hedge should look like this:

1. LP opens a short position, i.e. negative exposure to the implied volatility
2. LP buys some puts and calls contracts with the same strike and the highest possible Vega, creating a straddle. The number of contract should be 12 * Vega*T365 , the same for puts and call, making the combination both Delta-neutral and Vega-neutral

A solution one can consider is using a strangle build from 2 distant OTM contracts with approximately zero summary delta. The problem to be solved is how many contracts to buy.

For now, our calculator finds the best-price contracts, which are distant OTM contracts as needed and uses the same formula 12 * Vega*T365

Long strangles and long straddles can be bought in decentralized apps such as — Lyra, Dopex and Hegic or centralized apps like Derbit.

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