Understanding Vega III
You need to watch Vega closely if you're trading a single option contact or doing a multi-leg strategy, especially if you like to trade calendar and diagonal spreads -- strategies that consist of option contracts that don't all expire in the same month. I've talked to many clients holding a calendar spread before an earning report because they expected the implied volatility to drop - only to find out after the trade that they were net long Vega. When volatility did drop, it actually hurt their position.
So, let's look at how you calculate Vega for an entire position. We will do this by looking at a fictitious position created in the TradeKing Profit + Loss Calculator (under the Tools menu). As in the last post, I'm using Google options expiring in September.
Let's start by looking just at the first position shown, the Buy 15 September 380 Strike Puts at 14.70. The Vega for a single option contract is .584 or 58.4 cents, but we're buying 15 of them. So multiply 15 contracts x 100 shares per contact x by Vega .584 to get a position Vega of 876 -- or, without rounding, 875.95, as the graphic below shows. The upshot is this: if the implied volatility for this option contract moves one percentage point, this position will gain or lose $876 in total. You would do this for each Google option position in the account.
Did you notice the sell on 5 Sep 400 calls has a negative Vega? That means the position will lose value if the implied volatility of the option increases. The total Vega for the position is displayed in the far right corner of the Profit + Loss Calculator, at the top: 1,788.32. In other words, the position will lose approximately $1,788.32 if the implied volatility dropped one percentage point.
It's important to note that Vega can only be calculated on a position (one underlying) basis. It makes no sense to calculate or total for an entire portfolio, because the volatility levels are usually very different across stocks. As you can see under the column heading, the Vega is calculated automatically for each individual option contract and they displayed across the top for the entire Google position.
Now for the disclaimer: each option does have its own implied volatility number, and sometimes the number does not change uniformly across all strikes and expirations. With that said, the position Vega is the best theoretical indication of what a change in implied volatility might do to your individual stock or index option position.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
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.
Edited by optionsguy at 09/03/11 at 07:00 AM