For a plain vanilla call, how is the vega neutral hedging done? I mean, how to take up positions in the underlying stock to make the portfolio vega neutral?Thanks

You usually maintain a vega neutral position by taking a position in another derivative (usually a call/put) on the same stock.

But keep in mind that it is not as straightforward as Delta hedging. Whereas there is only one underlying value, the volatility has in general a skew- and a time-structure....

Sam and Capcapo,Thank you for your help! "You usually maintain a vega neutral position by taking a position in another derivative (usually a call/put) on the same stock. "Sam, I guess do you mean static hedging?As I understand, static hedging covers risks in uncertaininty of all parameters like interest rate,etc. and doing static hedge reduces the maximum payoff. It is like paying insurance for all the risks.Assuming I know that only volatility is going to change and know its functional form, which instruments I need to use for hedging?Is there an analytical formula for calculating hedgebale amounts?Thanks

asdJust as Sam said, you can't use the stock to hedge vega. You need to use one (or more) other options. This does NOT imply static hedging, necessarily. Here's an example:Suppose you have two options with the following sensitivities:Sensitivity ... Option One ... Option TwoDelta ............. 0.5 ................ 0.6Gamma ......... 0.02 .............. 0.01Vega ............. 0.1 ................ 0.15Now suppose you decide to sell 150 of Option One and buy 100 of Option Two you have the following position:Risk ............ Option One .... Option Two ... TotalDelta ............. -75 .............. + 60 .............. -15Gamma ......... -3.0 ............. + 1.0 ............. - 2.0Vega ............. - 15.0 .......... + 15.0 ........... 0.0Assuming you sold 150 of Option One to a client, then you can hedge your vega risk by buying 100 of Option Two. However, as you can see, although this leaves you with a flat vega position, you now have a delta position of -15 and a gamma position of -2. You can hedge the delta position by buying 15 shares. However, to hedge the gamma, you need to buy some options. Moreover, tomorrow you will come in to work to find that you are no longer vega hedged either. Life's a b***h.HTH

remember that short term implied vols (implied vols from short term options) in general are much more volatile than long term vol (implied from long term options), I have seen fresh traders blow up on vega neutral portfolios, hedging vega in long term options using short term options. My first paper published in english, was a simple note about this topic (back in 1993) "The Opportunities and Perils of Using Option Sensitivities). Surprisingly several multi million dollar systems are now using this simple ad-hock way of calculating vega risk of option portfolios. Nassim Taleb also mentions various forms of weighted vega in his must have book "Dynamic Hedging" You can soon also use VIX futures to hedge vega, and in the OTC market vol-swaps (mainly in fx)

Johnny and Collector, Thanks very much !

Collector,I have tried to look for your article entitled "The Opportunities and Perils of Using Option Sensitivities" on the web but I wasn't able to find it. Could you tell me where I could download it or could you attach it in one of your message please ? I am really interested by this topic.Just another question from a newbie : Do you think "Dynamic Hedging" is a good buy for a beginner ? I read Natenberg but I am not sure about that one because it is said to have a lot of typos (perhaps very harmful for a beginner ???).Thank you in advance.

QuoteSurprisingly several multi million dollar systems are now using this simple ad-hock way of calculating vega risk of option portfoliosIs that a time-freezing arb ?

was putting up my old paper for downloade on bottom of my webpage just nowOpportunities and Perils in Using Option SensitivitiesPlease have in mind this was basically one of my very first papers, before I knew much about options. I know (and even knew then) that correlations between volatilities are highly unstable. But not weighting and then indirectly assuming correlation 1 is even worse. If you think you don't assume, you are making hidden assumptions!Also what you should look at for this is implied vols not so much historical, but at that time (in between 2 jobs) I only had historical. This is a big topic I could write a whole book on...will possibly write an article on it soon.It is certainly better to use some type of weighing than not, short term implied voles are for certain much more volatile than long term.Looking at historical as I did, you have problem with number of sample points, short term also get more volatile simply because less sample size etc. but this is not whole story, big events do not happen every day, and after a big event or 2 (days) one can expect vol to come down over time, strong "mean reverting" after vol shocks, which is part of explenation why even short term implied more volatile than long term. But there is much more to it, most non-traders got the whole volatility concept wrong....I will come back to this later.Main point from this paper is simply short term vol (and should have looked at implied) are much more volatile than long term.The 3D portfolio charts I was running in Wingz back then (early 90s), Excel was horrible at that time. As I rember UBS and their brilliant option team at that time was using Wingz running on Steve Jobs was it Nextel? the computer company he was building up when he took a leave from apple....Both Steve Jobs computers and Wingz was superior to most other products. Still Nextel did not pick up volumes, neither did Wingz....Just a proving Marketing can be more important than having the best product.... My option system back then let me view Greeks for whole option portfolios in 3D when other traders was in the "excel-stone age" , it was a great time.