This super pic of a Rube Goldberg machine is a great metaphor for the delicate interactions between factors in an options trade – and how adjusting one factor can make all the difference. Pauly B posed a great question on my Monday morning quarterback series on First Solar (FSLR), and it’s one I think lots of readers might be interested in. He writes:
“Brian, FSLR is an extremely high beta stock with very high implied volatility. Personally I don’t like to trade options on an underlying with a beta over 1.5 because of the vega risk, even with spreads. Yes, they have the ‘juice’ in the option price but that comes at a risk.
If you are setting up a spread for FSLR, what are you thinking about in terms of vega and the implied volatility chart? Would volatility time your entry into doing a spread on a stock like FSLR outside of earnings?”
Pauly B, let’s start by defining each term separately – because while the factors you mentioned are related in this trade, they can also be decoupled.
Beta compares the fluctuations of a stock to a benchmark index, usually the S&P 500 index (SPX). It’s calculated on historical price movements. For example, if a stock's beta is 1.5, it's theoretically 50% more volatile than the SPX.
Implied volatility (IV) is a forward-looking number specific to options. IV can fluctuate even if the underlying stock does not move – it’s often driven by current news and fear, not by actual stock price movement. IV shows what the marketplace is "implying" the volatility of the underlying security to be in the future. IV is derived from the options price and calculated using an options pricing model. If no options trade in a security, then naturally there is no implied volatility for that security. (I did a five-part series on why traders care about volatility – check it out.)
Vega goes along with IV and has nothing to do with beta. Vega is defined as the amount a theoretical option's price will change for a corresponding one-unit (point) change in the implied volatility of the option contract. (Take a look at my three-part series on vega, too.)
Okay, we’ve labeled the game-pieces – let’s start the play. Based on your comment, we’re examining the following trade set-up:
With FSLR at 149.93 on 1/12/09, the individual contracts and their prices in the spread were:
Buy Jan 155 Put at 8.80
Sell Jan 145 Put at 4.00
Net debit for the spread of 4.80
(Assuming a one contract spread, there are total commission costs of $22.40 to enter and exit this trade: $4.95 per leg plus 65 cents per contract traded).
This spread is vulnerable to two risks: vega risk and time decay, or theta. (And if you’re wondering if the Options Guy has a blog series on theta, well, there’s your answer.)
How big of a risk comes down to the time premium in the options you’re selling and buying. Why? To explain, let’s look at the price of each leg of the trade independently.
The 155 put had $5.07 worth of intrinsic value (strike - stock price, or 155 – 149.93) and $3.73 worth of time value (option price – intrinsic value, or 8.80 – 5.07).
The 145 put was out-of-the-money, so the premium on 1/12 was all time value, $4.00. We’re actually paying less in time premium for the ITM option than we’re selling for the OTM option. This ultimately makes time decay and vega risk neutralized.
In other words, a fluctuation in IV would affect both contracts almost the same amount, because the time premium in them is almost the same. Another way to say that: each of these contracts had almost the same vega.
If we do stay in the position all the way to expiration, the time value will be zero and we will have paid less time premium than we received from the sell. Even though we purchased this spread and paid a debit for it, the trade likes time premium to erode either via a drop in IV or because of actual time decay (theta).
To look up vegas and thetas for each individual leg as well as the net position, TradeKing’s Profit + Loss Calculator can help you look that up.
ITM versus OTM spreads and vega
What’s interesting is that an OTM version of this spread generates a different time-premium scenario, with a different effect on vega as a result. Consider this OTM spread:
Buy Jan 140 Put at 2.55
Sell Jan 130 Put at 1.00
Net debit for the spread of 1.55
(Assuming a one contract spread, this trade also has total commissions of $22.40 to enter and exit this trade: $4.95 per leg plus 65 cents per contract traded).
These are both OTM options, so they consist of only time premium. Unlike the ITM example above, we’re selling much less time premium ($1.00) than we’re buying ($2.55). That apparently little different means the 140 strike’s vega is double that of the 130 strike; a drop in volatility will hurt this position.
What’s the moral of the story? You’re right: you can nullify vega’s potentially dangerous “juice” on the trade by choosing the strikes for your spread carefully. In my Monday morning quarterback comparisons I used the same dollar amounts across the board, so controlling vega might have translated to buying fewer ITM spread spreads (versus a lot of OTM spreads) to take care of your vega concern.
What about beta?
Haven’t forgotten the beta angle to your question, Pauly. If stocks like FSLR move too fast for your investing style, that’s a valid concern and might keep you out of the trade. These spreads we’ve been describing are tough enough to require lots of monitoring, which doesn’t suit everyone. But for our vega-neutral spread above, vega risk wouldn’t be what keeps you up at nights – beta, or the actual stock movement, would be the culprit there.
Your stomach might stay more settled if you trade options on stocks that track the larger market more closely – in which case you’d seek out stocks with a beta closer to one.
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
[image: Máquina de Rube Goldberg en la base del Alinghi by freshwater2006 on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
While Vega represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (point) change the implied volatility the option contract there is no guarantee that this forecast will be correct.
While Theta represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract there is no guarantee that this forecast will be correct.
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