The market has been a volatile machine as of late. Option prices and implied volatility levels have moved higher in response. That said, implied volatility and option prices are destined to come back down again if and when the market rallies. Generally, IV levels move higher when the market drops, and IV levels drop when the market rallies. If you have an option position with positive vega (long options), this might be a bit concerning for you. If it is, and it probably should be to some degree, one way you can offset that risk for a directional trade is by using a spread.
Let’s keep this lesson short, simple and to the point. Option prices are affected by implied volatility. If IV is higher than normal, option prices tend to be high. If IV is in the lower part of its range, option prices tend to fall. Option vega changes the price of an option for every 1% change in IV.
Take a look at the example below. The red line represents implied volatility, and the turquoise line represents historical volatility. Without getting deep into the woods, option prices are above historical levels currently: 16% historically and about 22% currently.
IV is at about 22%. If it were to move up 1 percentage point to about 23%, the option would increase in value by 0.11 because of vega (see chart below). The new value would be about 2.98 (2.87 + 0.11). That would be beneficial for the position. But what if IV levels dropped to historical levels if the underlying rallied? If IV decreased by 6% (22% – 16%) to about 16%, the new option value would be about 2.21 (2.87 – (6 X 0.11)).
Clearly if you bought the option, you would prefer the option to increase in value, and it would (based solely on vega) if IV did increase. If IV is high because the market has fallen and you expect stock prices to rise and IV to drop again, you need to be cognizant to this. Don’t get me wrong. Positive delta and a move higher would offset some if not all the vega loss in this instance. But if you can do something about it, why wouldn’t you?
Use a Spread to Neutralize Risk
This is a situation where you would not want to have a positive vega position like a long call. If IV decreases as the market and stock move higher, vega would decrease the premium. So what should an option trader consider?
A spread like a bull call could neutralize that positive vega risk. A bull call involves buying a call and selling a higher strike call with the same expiration. The position can benefit from a move higher in the underlying, and it is considered bullish. Take a look at the example below.
The 180 call is bought and the 182 call is sold. But take a look at the vega on the position. Before selling the 182 call, the position had a positive vega of 0.11. Now by selling the 182 call, the vega position is essentially neutral (0.11 – 0.11). So if IV drops, the position will not be as affected as it was before when the position had positive vega and would have lost premium.
This is just one way to offset vega risk. It can be rather effective, however, particularly in down markets when a move higher is expected.
Senior Options Instructor