Many options traders don’t realize how much volatility changes can impact their positions – even more than changes in the underlying’s price. This post continues a blog series on volatility in options trading, focusing on position vega.

Welcome back to my series on volatility in options trading. If you’re just joining us, feel free to catch up on my seven previous posts by jumping to the section below titled “Just tuning in? Previous volatility posts in this series”.

My last post Volatility and Position Vega issued a friendly challenge: can you figure out the position vega of the spread example outlined below? I promised a free copy of the newly expanded Options Playbook to the person who answered correctly first. Let’s recap the question, shall we?

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.

(Before I break the suspense, an important reminder: 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. Also, 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.)

As it turned out, that caveat at the end was the telling detail. If we assume zero carry costs and the time value and Implied Volatility (IV) are the same for each option, in theory vega should also be the same for each leg. Since we bought one and sold one option, their position vega values should have cancelled each other out and the net position vega would be exactly zero.

The time distribution chart below removes the time value from the in-the-money strike (50), so you can see that the time value on each of these legs is exactly equal. If all other factors remain unchanged, equal time value usually translates to equal vega.



This makes Newbtrader first across the finish line as our winner. Not only did he supply the right number, but he had a solid explanation to go with it. Nice work!

Now, keep in mind: that set of assumptions above was very theoretical. If the stock moves up or down – as stocks certainly do in reality – the vega of each option can and will change. If you take one big-picture idea away from this post, that should be it. If the stock goes towards the 55 strike before expiration, this strategy will have a negative position vega (that is, it will be effectively rooting for IV to decrease). If the stock moves instead toward the 50 strike, the position vega will become positive (rooting for IV to increase).


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

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