The Effect of Vega
Sep 19, 2018
By: Sage Anderson
While many traders focus a lot of attention on delta and theta, another "Greek" that is very important to monitor is vega.
As a reminder, the "Greeks" refer to a group of parameters that measure the different risk characteristics of a given options position. For example, an option's delta provides insight on how much its value will change for every $1 change in the underlying stock. Theta tells us how much an options value will theoretically change with the passing of each day.
Vega is the Greek that reports how the value of an option changes with increases or decreases in implied volatility. In this regard, vega helps traders understand how sensitive an option is to changes in the “speed of the market.”
Looking at an example, imagine a hypothetical put in SPY has a vega of 0.20. That means that if the VIX goes up by 1, the value of that option will theoretically increase by $0.20. Likewise, if the VIX drops by 1, then the value of that option should theoretically decrease by $0.20. If you are short the option and the VIX goes down by 1, that’s obviously beneficial to the position.
Because vega is so crucial to the ever-changing value of an option, it's important for traders to understand its dynamics and behavior, a topic that was recently highlighted on a new installment of Market Measures, entitled "The Effect of Vega."
The first important point illustrated on Market Measures is the fact that vega approaches zero as expiration draws closer, as demonstrated in the chart below:
Considering that most options traders opt to get short premium when implied volatility is “rich,” the above appears to work to the advantage of such an approach - especially when banking on a reversion to the mean. How then, can traders maximize the vega component of a given position?
In order to understand that, we briefly need to point out that vega is positively correlated to the following variables:
Price of the underlying
Given that high levels of implied volatility are already a trading signal for many short premium approaches, we can move past that one relatively quickly when talking about the analysis of a potential trade.
In addition, we may not necessarily want to make trading decisions solely based on the “price of the underlying,” which means the remaining variable listed above deserves some extra attention.
The remaining factor listed above is “time” - meaning that traders seeking to capitalize on high vega should also be reviewing positions with a higher number of “days-to-expiration” (TE). This indicator dovetails extremely well with previous tastytrade research suggesting that “45 DTE” represents a potential “sweet spot” for short premium positions.
By extending the time to expiration, short premium traders can therefore try and leverage both vega and theta for contributions to the bottom line.
Not too long ago, a separate installment of Market Measures compared the side-by-side historical performance of options with 7 days-to-expiration (weeklies) to that of 45 days-to-expiration options (monthlies), and the results of this research further support the notion that longer-dated options “pack more punch.”
If you have any outstanding questions on vega, or any other trading-related topic, don’t hesitate to reach out by leaving a message in the space below, or sending an email to email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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