Implied volatility (IV) levels have drifted a little higher recently. At some point, the market will sell off and they will rise even more. If you initialize an option position with positive vega when IV is high, this might be a bit concerning for you. But there is a way to help neutralize that vega. Instead of a long call or put, consider a vertical debit.
Before We Dive In
It’s pretty simple to do this, but let’s start with a quick IV refresher. 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 (based on historical levels), 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.
IV is just over 49%. If it moves up to about 52%, the option would increase in value by 0.12 (3 X 0.04) because of vega. The new value would be about 2.73 (2.61 + 0.12). If IV decreased by 3%, down to about 46%, the new option value would be about 2.49 (2.61 – 0.12). Clearly if you bought the option, you prefer the option to increase in value and it would (based solely on vega) if IV did increase. But what if IV is high because the market has fallen, and now you expect stock prices to rise and IV to drop again?
Unwanted Positive Vega
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 might an option trader consider doing?
A spread like a bull call could help neutralize that unwanted 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 a bullish position. Take a look at the example below.
The 133 call is bought and the 135 call is sold. But take a look at the vega on the position. Before selling the 135 call, the position had a positive vega of 0.04. Now by selling the 135 call, the vega position is essentially neutral (0.04 – 0.04). So if IV drops, the position will not be as affected as it was before when the position had an overall positive vega and would have lost premium. Of course, there are trade-offs with the spread like limited potential profit that the long call would not have had for instance. But with options, there are always trade-offs!
Final Thoughts
Of course, there are other option strategies you can use to offset vega risk. But the example above can be rather effective, particularly in down markets when a move higher is expected along with an IV drop.
