V is For Vega

I talk a lot here about how I think the market is overly complacent, implied volatility is too low, options are relatively cheap and I believe all that to be true. But.... the reality is that the Great Rally of 2013 really hasn't been very volatile.

Of 2013's 222 trading days, the S&P 500 has closed 130 days less than 0.5% higher or lower.  5 have been +/- >1.5%; and just 1 day +/- >2% (thanks to www.ntmarkets.com for that arresting statistic).

Apart from a few (very few) downdrafts the stock market has basically just moved steadily higher. It's been an absolute Bear Killer of a market and also death to buyers of option premium.

But, what I want to talk about today is trading option volatility in the form of spreads. Being volatility neutral, in other words. The measure for an option position's volatility exposure is called Vega.

The Vega of an option is the measure of the impact of changes in the underlying volatility on the option price. Specifically, the Vega of an option expresses the change in the price of the option for every 1% change in underlying volatility.

Foe example, let's take stock XYZ trading 46 and the 3 month 50 call is trading at 2. We'll assume that the Vega of the option is 0.15 and that the underlying volatility of XYZ is 25%.

If the underlying volatility goes up 1% to 26%, then the price of the option should rise to 2 + 0.15 = 2.15.

However, if the volatility had gone down by 2% to 23% instead, then the option price should drop to 2 - (2 x 0.15) = 1.70.

Time impacts Vega as follows: The more time remaining until expiration, the higher the Vega. This makes sense as time value  makes up a larger proportion of the premium for longer term options and it is the time value that is most sensitive to changes in volatility.

What this means in practical terms is that it is prudent to spread Vega if you are running a large option position. If you are long a lot of option premium (Vega) in one particular month then it is prudent to sell option premium in an other month so as to have a balanced position.

I know that this is not really important to the average home trader but is illustrative of how professional traders think about and manage their positions.


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