The market can be very volatile, and if you have traded at all over the past several months you know that very well. As an option trader, you probably are and definitely need to be familiar with how implied volatility changes can affect option prices and the way you think about different strategies. Let’s look at something I covered in MTM’s Group Coaching class on one of those volatile days when the market was all over the place.
Let’s start with defining vega. Option vega is the measurement of the option’s price sensitivity to changes in the volatility of the underlying. Keeping it simple, as 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 constantly as of late, you can see how option prices may be affected. Generally, when markets and stocks rise, IV drops with option prices; and when market and stocks fall, IV rises with option prices.
On a recent trading day, the market and the SPDR S&P 500 ETF (SPY) gapped lower to start the session. Looking at a chart, the SPY moved lower for several sessions before this gap lower 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. For this example, the chart is not as important as understanding the general concept.
With the big move lower, IV levels were elevated along with option prices. If a move higher was expected because of being extended and/or because of potential support, IV would most likely drop to some degree as well. We considered a long call option, but a long call has positive vega and an IV drop would decrease the premium. Now don’t get me wrong, a vigorous move higher and a positive delta could certainly overcome some vega loss, but there might be another alternative.
Bull Call Spread
We also explored a bull call spread. In this case, we modeled out a 430/450 bull call spread with about two weeks to go until expiration. Without getting into too much detail other than vega, there are trade-offs between a long call and a bull call spread. Among them is that the max profit of a long call is unlimited and the spread is limited due to the short call. But in this case, we were focused on the vega position. The spread would have both positive vega (long call) and negative vega (short call) to limit vega exposure compared with the long call on its own. With an IV drop expected because of the anticipated move higher, neutralizing the vega position versus just a positive vega position seemed like a valid option. Since the discussion, the SPY has moved higher and IV levels have dropped.
Let’s once again keep it simple. If you have a positive vega position and expect an IV drop, consider a spread to offset that exposure. If you have a negative vega position and expect an IV rise, consider a spread to offset that exposure. As you can tell, a spread can limit exposure but can also limit gains. As always, everything in options is a trade-off and the most important part about the trade is still that the underlying does as forecast. Otherwise, worrying about your vega will not matter.
Senior Options Instructor