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Advanced Options Trading - Vega

Filed Under Advanced Options Trading 

According to Option University’s Ron Ianieri, “just about every trader you see will tell you that their money was made through Vega. That’s how important Vega is.” Likewise, Vega is probably the source of most of the losses in the options market for new options traders. So, now that I’ve got your attention, let’s talk a bit more about this important Greek output of the Option Pricing Model.
 
Vega measures the change in an option’s price per one tick movement (a tick is one whole number in volatility). Vega is given as cents and is going to tell us how much an option’s price is going to change when volatility moves and it’s going to quantify this for us per strike for every option. For example, if Vega is .060 at a certain strike price-regardless if it is put or call- that means if volatility moves up from, let’s say 30 to 31, the price of the option-either call or put- will move up 6 cents.
 
Why is it important to know about Vega?
 
Perhaps an example will best explain it. Suppose you think a stock is going up and the stock is currently trading at $56 or $57 and you look at it and look at the 50 strike calls and they’re only trading for .80 or .90 cents. This price is really cheap, so you buy those calls. Sure enough, the stock trades all the way up to $59.5 in three weeks and you look at your option and you see that the option is now trading for .70 cents-less than you paid for it and you can’t understand what happened. The stock went up like you thought it would, but not the option!
 
As Ron Ianieri explains in his Options Mastery Class at Options University, what probably really got you here was Vega. You see, as that stock traded up in a nice, slow, gingerly fashion, implied volatility decreased and as it decreased the value of your option decreased by the amount of the Vega, which trumped the effects of Delta.
 
So, what can option traders do is take Vega and anticipate what the price of the option will be with any movement in volatility? That’s why understanding Vega is so important.
 
When volatility increases all the options increase in price and when volatility goes down option prices also go down. If an option trader wanted to play stock direction, they want to play Delta. The last thing they want to do is to have Vega creep into the picture and destroy Delta profits. How does a trader do that?  The simple answer is to look specifically for options that are not real sensitive to volatility: we look for options with low Vega’s.
 
Vega sensitivities are higher in the out month options. If a trader buys an option, especially an out month option, as it gets closer and closer to expiration its volatility sensitivity decreases. Remember the “volatility smile”? The option becomes less and less sensitive to movements in implied volatility meaning an option needs bigger movements in the underlying to move the value of the option as expiration gets closer and closer.
 
This fact is important because that means if an option trader wants to play volatility they might want to go out a little further; maybe  instead of buying a first or second month option, go out to four, five or six months.
 
For more information on all aspects of stock options, go to: www.www.optionsuniversity.com

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