Two greeks are increasingly mentioned as traders seek to better define the impact of the options market: vanna and charm. We wanted to provide some definitions and basic applications of these measurements in an effort to explain why these factors matter.
This post will be seen through the lens of of an options dealer in the SPX. Our basic model assumes that dealers are net short put options, and net long call options.
- Vanna – measures delta change for a given change in implied volatility[IV]. Short puts and long calls have positive vanna. Therefore as IV declines/rises SPX dealers must buy/sell hedges.
- Charm – measures delta change for a given change in time. As out of the money options decay, dealers have to buy back futures.
Take an event like the 11/3 elections. IV was very high (as shown by the VIX) and traders were buying put hedges to protect themselves. Accordingly dealers were likely short futures as a hedge against that risk. After the event, IV plummeted which destroyed out of the money put values, allowing dealers to buy back short futures.
As you can see in the chart below, as time passes an options delta changes. Charm seeks to measure this change. This chart samples options over a fairly long time horizon. Recall that weekly options are now very popular and functioning with the same decay but in a much shorter time frame.
Each day that passes, out of the money options require less delta hedging, and in the money options require more. Lets say that a dealer is short 100 shares of stock to hedge an out of the money put that expires in 5 days. Each day that passes (all else equal) the dealer can buy back more and more shares.
Now project that idea to a portfolio of options, particularly around an event like the election which was on 11/3. There were thousands of very short dated, out of the money put options expiring on 11/4 and 11/6 alone.
A similar situation could happen around a single stock name like TSLA wherein traders are buying out of the money weekly calls (dealers net short calls). Each day that passes (again, all else equal) those calls decay leading to dealer long share unwinds.
As you can see in the charts below as IV shifts the hedging requirements change. If we work off of the these assumptions that dealers are short SPX puts & long calls, you can see that the out of the money delta moves toward zero as IV drops. Therefore dealers would be buying/selling futures as IV declines/increases.