Welcome back to my series on volatility crunch. So far we’ve explored how volatility crunch can nab you when you buy cheap, very-OTM options on underlyings with big-time volatility. Last week we reviewed how implied volatility often settles down as markets go up, deflating the value of long option positions; we also discussed some alternate strategies to consider that might minimize your chances of getting “crunched”. Now I bet some of you are thinking: well, if the problem is that my cheap OTM options are expiring too fast for the big move to happen before expiration, I’ll just buy way-OTM LEAPS and buy myself more time. (“LEAPS” stands for Long-Term Equity AnticiPation Securities, essentially an option with a much longer lifespan than the usual contracts.) Unfortunately, while this makes sense in theory it doesn’t usually pan out in practice. To explain, we’ll need to re-introduce the concept of vega.
What’s vega?
Vega is the Greek that follows implied volatility (IV) swings. Formally speaking, vega is defined as the amount a theoretical option's price changes for every one-unit (percentage point) change in the implied volatility of the option contract.
A few rules-of-thumb on Vega:
• Vega is typically larger for options with more extrinsic (time) value. The further out you go in time, the larger the percentage of the option price will be extrinsic value or time premium. That means longer-dated options like LEAPS will usually have larger Vegas than the near-term contracts.
• Vega is also usually higher for option contracts trading with higher implied volatilities. High volatility levels typically drive up an option contract’s price, too.
An example: back to WM
Last week we looked at Washington Mutual (WM), so let’s stick with that example.
Say we bought 10 lots of two call contracts, one very near-term and the other further out in time, with the same strike price. Let’s compare the position vega and see in dollars how much a one-point move in IV can affect each position.
Buy 10 Feb08 17.50 calls at 0.45, position vega = .013 x 10 x 100 or 13.00
Buy 10 Jan10 17.50 calls at 3.10, position vega = .077 x 10 x 100 or 77.00
So theoretically if IV on each of these options decreases by 1%, the long positions may decrease in value by $13 and $77 dollars respectively. It’s clear that the long-term contract isn’t protecting you much from the effects of volatility swings. In fact, a 1% move in IV will affect both of the positions more or less equally on a percentage basis.
The cost of the Feb08 position is 0.45 x 10 x 100 = $450 so 13/450 is 2.8%
The cost of the Jan10 position is 3.10 x 10 x 100 = $3100 so 77/3100 is 2.5%
The percentage change in the LEAPS position is almost the same as the near-term – but remember, this is just a 1% move we’re talking about. Given current market conditions in the financial services sector, the implied volatility of these options can easily move up or down 5% to 10% in a short time period.
Cheer up!
If I’ve managed to scare you away from buying OTM, high-IV options forever, that’s not my plan. There’s a fine balance here of various factors affecting your position, and hopefully you’ll recognize how each of those factors impacts your position. Also, I did provide some alternative strategies in the previous post if you are really concerned.
Back to the example above: if IV continues to rise beyond a 1% change, that’s a good thing for the long options trader. But keep in mind that, as prices on the underlying rise (good for long call traders), IV usually declines (not as good for long call traders). In other words: it’s good to be right on direction, but once the underlying starts moving clearly upwards, it tends to deflate the fear that drives higher IV – and with that deflation, you’re going to lose a little value. As long as you didn’t choose way-OTM options, though, chances are good that you can ride this wave of changes successfully and come out with some profit at the other end. If the call options do become ITM options, more often than not the position will be a very successful trade; the main issue is when the underlying doesn’t quite make it to the strike price.
Once in a blue moon, stocks can rise strongly and IV doesn’t decline or actually increases – that’s happening right now in the financial services sector. We’re seeing rallies on those stocks, but there’s still quite a lot of fear, too. In those rare circumstances, as a long call trader you could be benefiting from both factors at once. Then again, many long call traders don’t realize how, “under the hood”, these two usually opposing factors are working together to help his trade. When this scenario happens, nobody usually calls up to ask: “Wait a minute, I’m making way more money than I should be!” ?
Final caveats…
Now for a disclaimer: each option does have its own IV number, and sometimes that number does not change uniformly across all strikes and expirations. With that said, position vega is the best theoretical indication of what a change in implied volatility might do to your individual stock or index option position. And as we’ve demonstrated here, those high-IV LEAPS have pretty much the same vulnerability to fluctuations in IV as near-term options do.
Until next week then!
Regards,
Brian (OG)
[image: The Leap by Jesse Gardner on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
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.
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.
