If you have traded over the past several weeks, you have undoubtedly noticed how volatile the market has been. As an option trader, you are or probably should be familiar with how implied volatility changes can affect option prices. Below we will take a look at a topic I covered in class a couple of weeks ago when the market was seemingly all over the place.
Option vega is the measurement of the option’s price sensitivity to changes in the volatility of the underlying. To keep it simple, like I generally like to do, vega changes the premium of the option for every 1% change in implied volatility (IV). If IV rises, option prices rise and vice versa. With the market and stock rising and falling unconsciously lately, you can see how option prices may be affected. Generally, when markets and stocks rise, IV drops and when market and stocks fall, IV rises.
On Thursday, Feb. 24, the market and the SPDR S&P 500 ETF (SPY) gapped lower to start the session. A chart of the ETF showed it had moved lower for several sessions and might have been a tad extended to the downside. In addition, the ETF had some potential support where it was currently trading that might provide a boost higher again. With a big move lower, IV levels were elevated along with option prices. If a move higher was expected, IV would most likely drop to some degree as well. A long call option was considered, but a long call has positive vega and an IV drop would decrease the premium.
Bull Call Spread
We also looked at a bull call spread. In this case, we modeled out an Apr-14 420/440 bull call spread. Without getting into too much detail other than vega, there are clearly trade-offs between a long call and a bull call spread with one being the max profit of a long call is unlimited and the spread limited. But here we are focused on the vega position. The spread would have both positive (long call) and negative (short call) to limit vega exposure compared with the long call on its own. With an IV drop expected, neutralizing the vega position versus just a positive vega position seemed like the correct choice. On a side note, the SPY moved over $20 higher by Friday’s close, which did wonders for a profitable position.
If you have a positive vega position and expect an IV drop, a spread can offset that exposure. If you have a negative vega position and expect an IV rise, a spread can offset that exposure as well. However, as you can see, a spread can also limit gains. As always, everything in options is a trade-off.
Senior Options Instructor
Market Taker Mentoring, Inc.