Using Vega to Assess Risk
Jun 14, 2016
After beginning the year at an elevated level, volatility began contracting the second half of February and has hovered below $16 since mid-March. Over the past couple weeks, volatility has stabilized and is climbing higher. We know option premium becomes rich with higher volatility. Existing positions; however, may be at risk because of Vega exposure.
Vega is a theoretical measure of how the price of an option may react to a change in implied volatility. Platforms such as thinkorswim display Vega to indicate risk based on a one-point change in volatility. For example, assume a short put position in SPY with Vega of -10 and VIX at $12. Should VIX move up to $20, based on Vega we could expect a loss of $80 (($20 - $12) x -10).
Options with different strike prices will have different Vegas. We see that with all the Greeks. It makes sense, therefore, that options closest to being at-the-money have the most exposure to volatility. Changes in implied volatility will affect these options more so than options further out-of-the-money.
Selling premium is what tastylivers do. When we sell options, we become short Vega and take on negative volatility risk. That means increasing volatility causes the price of an option to increase. Since tastylivers are typically short options and short Vega, increasing volatility works against existing positions. Long option positions are long Vega and benefit from increasing volatility. This is why we sometimes see short calls increase in price, despite falling prices.
Vega is no different from any of the Greeks in that it is a theoretical. It’s intended to give an assessment, not an absolute. Understanding Vega allows us to understand risk relative to increasing volatility. We may be right in directional trades, but volatility and Vega may offset being right.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, digital asset, other product, transaction, or investment strategy is suitable for any person. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastylive is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer. Options, futures, and futures options are not suitable for all investors. Prior to trading securities, options, futures, or futures options, please read the applicable risk disclosures, including, but not limited to, the Characteristics and Risks of Standardized Options Disclosure and the Futures and Exchange-Traded Options Risk Disclosure found on tastytrade.com/disclosures.
tastytrade, Inc. ("tastytrade”) is a registered broker-dealer and member of FINRA, NFA, and SIPC. tastytrade was previously known as tastyworks, Inc. (“tastyworks”). tastytrade offers self-directed brokerage accounts to its customers. tastytrade does not give financial or trading advice, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastytrade’s systems, services or products. tastytrade is a wholly-owned subsidiary of tastylive, Inc.
tastytrade has entered into a Marketing Agreement with tastylive (“Marketing Agent”) whereby tastytrade pays compensation to Marketing Agent to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. tastytrade and Marketing Agent are separate entities with their own products and services. tastylive is the parent company of tastytrade.
tastycrypto is provided solely by tasty Software Solutions, LLC. tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.