VEGA | UNDERSTANDING VOLATILITY ITS IMPLICATIONS

DEFINITION OF VEGA

The change of options value for a percentage point change in implied volatility of the underlying.

Vega is the one of the most underestimated greek in terms of how much impact it can have on the options position. Understanding vega and its effect on an option position is a key to successful trading.

 

UNDERSTANDING VEGA

When the uncertainty in the stock increases which could be due of various reason broadly classified into systematic risk and unsystematic risk. This affects the volatility in the underlying due to increased uncertainty in the stock. This again increases the value of the option premium.

Uncertainty is closely related to risk when the risk increases the premium of the stock increases. To understand this better apt example would be how insurance pricing works. For example, when the number of road accidents increases over the years the risk increase due to more number of people claiming for indemnity this, in turn, increases the premium value. Same is the case of mortality rate in case of Life Insurance. More the mortality rate more the premium since there is more risk involved. One must have noticed that as the age increase the premium increases because the uncertainty increases.

Now that we have understood why risk and uncertainty increase the premium let us understand how it impacts an option position.

VEGA TO DETERMINE CHEAP OR EXPENSIVE

Vega value is very useful to decide that the value of the option is available cheap or is it expensive. This plays a very important role in selecting the strategy. Based on the historical implied volatility for the underlying one can judge if the implied volatility is above the mean or below the mean based on that the premium can be determined.

CALL OPTION & PUT OPTION PREMIUM VERSUS DAYS TO EXPIRY

Generally speaking, the volatility is a little higher for put options compared to the call options.

But that does not affect the Vega.

Days to expiry have a major impact vega.Premium increase when the volatility increases and at the same time when the volatility decreases the premium decreases.  More the days to expiry more the option premium increase on increase of the implied volatility. In other words, more time to expiry higher is the probability of uncertainties increasing.

VEGA FOR LONG & SHORT OPTIONS

Long options strategy or Net long portfolio position benefits when the volatility increases. It can be also looked as when the current implied volatility is all time low of historical implied volatility the strategy selection usually goes for long option strategy. Caveat long option strategy is unlimited profit and limited loss strategy but it has to be done with utmost caution.

Short options strategy or Net Short portfolio position benefits when the volatility decreases. Another way around is when the current implied volatility is all time high of historical volatility the strategy selection usually goes for short option strategy. Only when volatility is high because of certain systematic or unsystematic uncertainties the volatility increases and option premium is high. Challenge is that there are chances of prolonged uncertainties.

Strategy wise volatility is a very big topic and would be discussed in their respective strategy posts.

Do let us know if you want us to cover any specific topics related to Option Greek & OptionsTrading Strategies.

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