How do we hedge option vega practically?

Question

Suppose I’m a market maker, and I collect some spread buying an option due the flow I get. In this example, I must always quote. I want to hedge as much of the risk as possible over the lifetime of the option as cheaply as possible so that I can keep as much of that spread as possible.

I’m content with hedging delta and vega. Delta is easy enough, especially if the name is liquid. But what about vega? Won’t I end up paying the same spread I just gained if I start selling options in the market to balance my vega?

Practically, how do we hedge without losing money? Does this change if the flow that causes me to buy options is very one-sided (biasing me towards buying instead of selling)?

Answer 1

If you are a market maker, your primary Vega hedge is to sell Vega to other clients. You do this by being the best offered side price in the market, so you will attract the next piece of business. This does require holding the position for some time while you try to generate business , but that is the job of a market maker.

Answer 2

Without losing money is a difficult one, just read a book that said that you can hedge vega with an at-the-money straddle. If you are the selling side, the only downside is that straddles require more margin than an iron condor or iron butterfly.

Answer 3

Just adding my 2 cents. The skill of the role is to collect bid offer on average. Therefore, there will most definitely be times where your positions carry you out and you are forced to lose some or all of this bid offer you have charged. But also, there will be times when the market moves in your favour and you are able to fully monetize bid offer either by being in the right direction or getting carried out by good two way flow.