Vega stocks: a case study

In this back-to-basics series for beginning options traders, TradeKing's Brian Overby explains vega, the Greek that measures how implied volatility changes impact your options position. Today's post explores the factors contributing to large vega, using a case study of GOOG and IBM.

Vega measures an option's sensitivity to swings in implied volatility (IV). Watching vega can give you crucial clues as to why your option's price is changing and where it may move next. Vega is just one of several options "Greeks", which help you measure the impact of variables on the price of your options – like interest rates, time passing, and so on – that will likely affect the price of your options contract. (While implied volatility and Vega represent the consensus of the marketplace as how a theoretical option’s price will change, there is no guarantee that this forecast will be correct.)

So far we've introduced delta and explained how delta is dynamic. We then discussed gamma and theta, the push-vs-pull relationship between those two, and calculating position theta.

A little trivia first about Vega, before we dive into its use. Vega is not actually a Greek letter -- but since it begins with "V" and measures changes in volatility, the name stuck as a useful mnemonic. Some of the actual Greek letters that are frequently used for changes in volatility are Omega , Kappa, or Tau. As it happens, vega is actually most commonly known as the brightest star in the constellation Lyra.

But enough trivia! In my last post we reviewed the usual characteristics of options with large Vega.  Here's a quick summary of those characteristics:

    Options with Large Vega:
            1) at-the-money vs in or out-of-the-money
            2) longer-term vs near-term
            3) expensive underlyings
            4) large implied volatility

To give you a more concrete feeling for what this all means, let's look at two very different stocks in regards to price, Google (GOOG) and IBM. (These stocks and symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security.) Google definitely has all the hallmarks of a high-vega stock: it's an expensive stock (trading ~$571) trades with an ATM implied volatility of 25%



First, let's compare the ATM strike to the In- and Out-of-The-Money strikes. True to our rule-of-thumbs above, the Vega is larger for the 570 strike: 0.66 or 66 cents. This means if the implied volatility of this option moves one percentage point up or down, the option value in theory will either increase or decrease by 66 cents accordingly.

You'll notice the vega on the 600 OTM strike is smaller (0.56, or 56 cents), but it represents a larger percentage of the option's premium. We're talking 56 cents on a $7.60 option (7.3%) vs 66 cents on a $19.10 option (3.4%). 

Now let's turn to the IBM call:



IBM stock is trading at a much lower per-share price than Google - around $125 - and with a little lower ATM implied volatility of 17%. The Vega for the ATM Strike (125) is 0.16 or 16 cents - which is smaller than Google's 570 ATM call (vega 0.66).

At the same time, on a percentage basis 16 cents is still a major factor in the price; 16 cents on a $3.10 option equates to 5% of the option price. When looking at vega on a percentage of price basis it shows why I think vega is the Rodney Dangerfield of the Greeks: it just doesn't get the respect it deserves.  If the IV of the option contract moves just 1% in the wrong direction, this will option lose a 5% of its value. This situation may cause the most annoying outcome for ATM option buyers: sometimes you're right about the direction, but you still lose on the trade because of an implied volatility crunch.

If you're buying an option, and you notice your susceptibility to vega looks high (for example, due to major news events), one way to counteract this is to buy a spread (buy one option while selling another). This way, if a drop in implied volatility is hurting the option you bought, it should be helping the option that you sold -- helping curtail the effects of the implied volatility.

(If you're not familiar with spreads, check out long call spreads in optionsplaybook.com for more info, including max potential losses and profits on the many types of spreads. Spreads are multiple-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.)

We'll talk more about vega, spread trading and the importance of checking position vega in my next post. Stay tuned!

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

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Even though the Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct.

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