Neutralizing Positive Option Vega

Posted on Thursday, November 29, 2018 at 4:09 PM

If and when this market decides to move higher, implied volatility and option prices are destined to come back down. If you have an option position with positive vega, this might be a bit concerning. If it is, and it probably should be, there is one way you can offset that risk for a directional trade and that is by using a spread.

Let’s keep this lesson fairly simple. 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.

With IV at about 42%, if that moved up to about 43%, the option would increase in value by 0.15 because of vega. The new value would be about 8.05 (7.90 + 0.15). If IV decreased by 1% to about 41%, the new option value would be about 7.75 (7.90 – 0.15). Clearly if you bought the option, you would prefer it to increase in value, and it would (based solely on vega) if IV increased. But what if IV is high because the market has fallen and now you expect stock prices to rise and IV to drop again?

This is a situation where you would not want to have a positive gamma position like a long call. If IV decreases as the market and stock moves 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.

In the example above, the 130 call is bought and the 133 call is sold. But take a look at the vega on the position. Before selling the 133 call, the position had a positive vega of 0.15. After selling the 133 call, the vega position is essentially neutral. 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, but it can be rather effective, particularly in down markets when a move higher is expected.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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