How to manage theta, gamma, vega, and delta risk in options market making simulation

Question

I'm just starting to learn how to trade options and as part of an algorithmic options market making simulation I have risk limits for the greeks (gamma, vega, delta, and theta).

There are 9 strikes total for the same underlying. I know to delta hedge with the underlying, but how should I go about managing the others? For example, is there a general rule of thumb to always minimize vega first? Or maybe it's a rule to reduce theta by buying/selling ATM options? Any general advice like that would be very helpful.

Thank you!

Answer 1

I'm not an expert in this field, but I think you need to define for us the source of profit/edge embedded in your market making strategy and the option trading strategy being utilised in order reach an answer on which risks to manage.

Some examples that come to mind:

a) if you believe your system models volatility better than other market participants and as a consequence you buy/sell options that in your model are under/over priced then it likely follows that remaining delta neutral is your primary concern, with theta/gamma being increasingly of concern if your strategy utilises shorter dated options.

b) if you believe your system models long term direction of the underlying better than other market participants then you probably need to keep your delta within some range and try to either max or min vega depending on whether your strategy leaves you long or short volatility

c) if you are HFT market making intraday with profit arising from the bid/ask spread and rebates, then you probably want to keep all the greeks close to zero.

In the absence of a specific driver, then a classic size x probability risk approach seems reasonable, i.e. model the dollar risk arising from a given movement/probability in each greek then in the first instance manage the one generating the most risk.

Hopefully an expert chimes in and corrects me if necessary.

Ian