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September 19, 2007

Inexperienced traders tend to overlook volatility when establishing an

option position. In order for these traders to get a handle on the
relationship between volatility and most options strategies, it’s essential to
understand the concept known as Vega.

Vega is a risk measure of the sensitivity of an option price to changes in

volatility. It is somewhat akin to Delta, which measures the sensitivity of an
option to changes in the underlying price. Both Vega and Delta can work at
the same time, and they can have a combined impact which either works
counter to one another or in concert. Thus, in order to fully understand
your option position, it’s necessary to assess both Delta and Vega. In this
tutorial chapter, we’ll explore Vega, with the ceteris paribus assumption
throughout for simplification.

Vega and the Greeks

All of the Greeks, including Delta, Theta, Rho, Gamma, and Vega, tell us
about the risk from the perspective of volatility. Options positions can
either be “long” volatility or “short” volatility (it’s also possible to be “flat”
volatility as well). In this case, long and short are terms referring to the
same relationship pattern as long and short in a stock position. That is, if
volatility increases and you are short volatility, you’ll experience losses,
ceteris paribus, and if volatility declines, you’ll have immediate unrealized
gains. Conversely, if you are long volatility and implied volatility rises, you’ll
experience unrealized gains, while declining IV will result in losses. (For
more on these factors see, Getting to Know The "Greeks".)

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Volatility is key to every strategy. Because both IV and historical volatility
can fluctuate rapidly and significantly, they can have a major impact on
options trading.

We’ll explore some examples to put this in real-world terms. First, let’s
examine Vega through the examples of buying calls and puts. Figures 1 and
2 provide a summary of the Vega sign (negative for short volatility and
positive for long volatility) for all outright options positions and for many
complex strategies.

- Vega Sign Rise in Fall in

IV IV

Long call Positive Gain Lose

Short Negative Lose Gain

call

Long put Positive Gain Lose

Short Negative Lose Gain

put

Figure 1: Outright options positions, Vega signs and profit and loss (ceteris
paribus).

Both the long call and the long put have positive Vega, meaning that they
are long volatility, while the short call and short put positions have
negative Vega (meaning they are short volatility). This refers back to the fact
that volatility is an input into the pricing model, and the higher the
volatility, the greater the price, because the probability of the stock moving
greater distances in the life of the option increases, as does the probability
of success for the buyer. Thus, option prices gain in value to incorporate
the new risk-reward. If you imagine the seller of the option in this case, it
makes sense: he or she would want to charge more if the seller’s risk
increased with the rise in volatility

- Vega Sign Rise in Fall in

IV IV

Short Strangle Negative Lose Gain

Short Straddle Negative Lose Gain

Long Strangle Positive Gain Lose

Long Straddle Positive Gain Lose

Backspread Positive Gain Lose

Ratio Spread Negative Lose Gain

Credit Spread Negative Lose Gain

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 Debit Spread Positive Gain Lose

Butterfly Spread Negative Lose Gain

Calendar Spread Positive Lose Gain

Figure 2: Complex options positions, Vega signs and profit and loss (ceteris
paribus).

At the same time, if volatility declines, the prices should be lower. When
you own a call or a put and volatility declines, the price of the option will
also decline. Of course, this is not beneficial, and it will result in a loss for
long calls and puts (see Figure 1). On the other hand, though, short call and
short put traders would experience a gain from a decline in volatility.
Volatility will have an immediate impact, and the size of the decline or gains
in price is dependent upon the size of Vega. Up to this point, we’ve seen
that the sign (negative or positive) of Vega implies changes in the price. The
magnitude of Vega is also important, as it determines the amount of gain
and loss. So what determines the size of Vega on a short and long call or
put?

Put simply, the size of the premium on the option is the source. The higher
the price, the larger the Vega will be. Thus, as you go farther out in time,
the Vega values can get increasingly large, eventually posing a significant
risk or reward should volatility change. As an example, if you buy a LEAPS
call option on a stock that was bottoming out, and then the desired price
rebound takes place, the volatility levels will usually decline sharply (Figure
3 shows this relationship on the S&P 500 index), and along with it the
option premium will decline as well.

Generated by OptionsVue 5 Options Analysis Software.

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 Figure 3: S&P 500 weekly price and volatility charts. Yellow bars highlight areas of
falling prices and rising implied and historical. Blue colored bars highlight areas of
rising prices and falling implied volatility.

Figure 3 shows weekly price bars for the S&P 500 alongside levels of
implied and historical volatility. In this chart, we can see how price and
volatility relate to one another. Most big cap stocks mimic the market;
when price declines, volatility rises, and vice versa. This relationship is
important to incorporate into strategy analysis because of the relationships
pointed out in the previous two charts. As an example, at the bottom of a
selloff, you would not want to establish a long strangle, backspread, or
other positive Vega trade, as a market rebound would pose a problem
because of declining volatility.

The Bottom Line

In this chapter, we’ve looked at the essential parameters of volatility risk in
popular option strategies. We’ve also examined why Vega is important to
consider as well. Of course, there are exceptions to the price-volatility
relationship evident in indexes like the S&P 500, but this is nonetheless a
solid foundation from which to explore other types of relationships. Next
up, we’ll look at vertical and horizontal skews.

Option Volatility: Vertical Skews and Horizontal Skews

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