Too many options traders undervalue how much volatility changes can impact their positions – even more than the underlying’s movement. This post continues an ongoing series on volatility in options trading, focusing on position vega. Welcome once more to my series on volatility in options trading. If you’re just tuning in, you can catch up on my six previous posts by jumping to the section below titled “Just tuning in? Previous volatility posts in this series”.
As always, don’t forget: 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’s no guarantee that this forecast will be correct.
Now to business! Today’s post will address a question many of you raised in response to my posts on calendar spreads – what about position vega? Folks, you’re absolutely correct: knowing the net volatility risk for all legs of a multi-leg position, a number called position vega, is critical to putting these theories into practice. So let’s jump into position vega today.
(Now’s a good time to mention: Spreads are multiple leg option strategies that involve additional risks and multiple commissions, and may result in complex tax treatments. Be sure to consult with your tax advisor before engaging in these strategies.)
The golden rule of ATM options, time value and volatility
I’ve been reiterating a key underlying concept throughout this series that bears repeating again: At-the-money (ATM) options prices are all time value, and these contracts tend to be the most affected by volatility changes. To illustrate this idea, consider the following theoretical example:
The contracts to the left are in-the-money (ITM), the ones to the right are out-of-the-money (OTM), and the 100 strike at the top is ATM. If you remove intrinsic value from the OTM contracts, you’ll see more clearly how time value and volatility meet their peak in the ATM contract:
Position vega: two real-world examples
Keep these principles in mind as we move on to two real-world historical examples. Along the way, you’ll see how position vega helps you understand how each leg contributes to the overall position’s vulnerability to implied volatility (IV).
Consider the following:
3M (MMM) trading at 70.80 on 8/19/09
MMM Sept 70 Call at 2.60 – IV = 28%, vega = .08
Note that this 3M call is another ATM option with ~30 days to expiration as of 8/19 – just like the theoretical ATM options we explored above. That means a 1% decrease in IV translates, in theory, to the option price decreasing to 2.52 (2.60 - .08).
That’s the single-leg vega. What if your position consisted of, say, 5 of these calls?
Long 5 Sept 70 Calls, bought at 2.60 = $1300
Market value $1300 (500 x 2.60)
Again, if IV decreases 1%, the net position’s value would theoretically decrease $40 (.08 x 500). If IV decreased 2%, that would translate into an $80 decrease, assuming all other factors stayed steady.
Now for the second example, in which IV increases by 1%. Let’s use the same setup as before, but switch the direction of the IV swing:
3M (MMM) trading at 70.80 on 8/19/09
MMM Sept 70 Call at 2.60 – IV = 28%, vega = .08
Vega tells us, in theory, that a 1% increase in IV would translate to the option price increasing to 2.68 (2.60 + .08). And if we held 5 of these long calls?
Long 5 Sept 70 Calls, bought at 2.60 = $1300
Market value $1300 (500 x 2.60)
If IV were to increase 1%, the net position’s value would increase $40 (.08 x 500) in theory. Again, a 2% increase in IV means a theoretical increase of $80 in the position, and so on.
Pop quiz! First correct answer wins a NEW Options Playbook
Let’s put that theory to the test. Consider the following theoretical spread and ask yourself: what’s the position vega?
The first comment to this post with the correct answer will win a NEW, expanded edition of the Options Playbook, just hitting bookstores now – plus bragging rights galore on this blog!
Here’s the setup:
Stock XYZ trading at 52.50
Buy 1 XYZ 50 30-Day Call 3.50
Sell 1 XYZ 55 30-Day Call 1.00
Net debit 2.50
Assume 0% interest rates, no dividends, and equal implied volatility for both options.
What’s the position vega? Tune in next time for the winner – and how to get your position vegas calculated automatically for you on TradeKing’s site. Good luck!
Just tuning in? Previous volatility posts in this series
My first post outlined 3 key volatility terms: implied versus historical volatility and vega, the Greek measuring volatility’s affect on an option’s price. Post 2, Volatility: When Vega Trumps Delta, explained how volatility crunch preys on long options. Post 3 dealt with volatility and long call spreads, and post 4 moved on to volatility and short call spreads.
I dealt with calendar spreads next in two posts. Post 5 explains how, despite many traders’ expectations, calendars don’t benefit from super-low volatility. Post 6 described a phenomenon known as volatility tilt that can affect calendars around earnings season.
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
[Image: Night Coaster by futureloveparadise on Flickr]
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