Using Vega to Assess Risk
Jun 14, 2016
By: Josh Fabian
After beginning the year at an elevated level, volatility began contracting the second half of February and has hovered below $16 since mid-March. Over the past couple weeks, volatility has stabilized and is climbing higher. We know option premium becomes rich with higher volatility. Existing positions; however, may be at risk because of Vega exposure.
Vega is a theoretical measure of how the price of an option may react to a change in implied volatility. Platforms such as thinkorswim display Vega to indicate risk based on a one-point change in volatility. For example, assume a short put position in SPY with Vega of -10 and VIX at $12. Should VIX move up to $20, based on Vega we could expect a loss of $80 (($20 - $12) x -10).
Options with different strike prices will have different Vegas. We see that with all the Greeks. It makes sense, therefore, that options closest to being at-the-money have the most exposure to volatility. Changes in implied volatility will affect these options more so than options further out-of-the-money.
Selling premium is what tastytraders do. When we sell options, we become short Vega and take on negative volatility risk. That means increasing volatility causes the price of an option to increase. Since tastytraders are typically short options and short Vega, increasing volatility works against existing positions. Long option positions are long Vega and benefit from increasing volatility. This is why we sometimes see short calls increase in price, despite falling prices.
Vega is no different from any of the Greeks in that it is a theoretical. It’s intended to give an assessment, not an absolute. Understanding Vega allows us to understand risk relative to increasing volatility. We may be right in directional trades, but volatility and Vega may offset being right.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.