What does it mean to long the convexity of options?

Asked by: Sandra Philley

From the point of view of risk management, being long convexity (having positive Gamma and hence (ignoring interest rates and Delta) negative Theta) means that one benefits from volatility (positive Gamma), but loses money over time (negative Theta) – one net profits if prices move more than expected, and net loses if …

What does convexity mean in options?

Convexity is a risk-management tool, used to measure and manage a portfolio’s exposure to market risk. Convexity is a measure of the curvature in the relationship between bond prices and bond yields. Convexity demonstrates how the duration of a bond changes as the interest rate changes.

Why is an option convex?

An option has convexity because the relationship between the price of the underlying asset and the value of the option is not linear. The option’s value will accelerate or decelerate depending on it being profitable when exercised.

Is high convexity good or bad?

Convexity in bonds is a way to measure the bond price’s sensitivity to changes in interest rates. Bonds with higher convexity are generally considered better investments in markets where interest rates are expected to rise, and lower convexity is better suited for when rates are likely to remain unchanged or fall.

How do you interpret convexity?

To interpret a convexity number, think of it as being the percent change in modified duration from a 1% change in yield. To estimate what the effect of including convexity in a price change calculation for a 1% change in yield, multiply the convexity by 1%^2=1%*1%.

What is convexity in volatility?

Volatility convexity reflects the relationship between vega and volatility. As volatility rises excessively, all options become concave with respect to volatility because every option is capped at the price of its underlying asset.

What does short convexity mean?

If you are short convexity, you become less exposed as the market moves favorably and you become more exposed as it moves the wrong direction (uh oh). One of the number one rules of the bond trading desk is to, all things being equal, always be long convexity.

What is a convex trade?

So a convexity trade is where you for instance buy that asset which has an upward- curved value (IE: a bond) and sell something that moves in a straight line with that factor (like some IR derivative). If that factor you’re thinking of (interest rates) really moves fast, you make money.

What is duration and convexity?

Duration measures the bond’s sensitivity to interest rate changes. Convexity relates to the interaction between a bond’s price and its yield as it experiences changes in interest rates. With coupon bonds, investors rely on a metric known as duration to measure a bond’s price sensitivity to changes in interest rates.