Option Volatility: Strategies and Volatility
Published orginally at Investopedia.com
By John Summa, CTA, PhD, Founder of OptionsNerd.com
When an option position is established, either net buying or selling, the volatility dimension often gets overlooked by inexperienced traders, largely due to lack of understanding. For traders to get a handle on the relationship of volatility to most options strategies, first it is necessary to explain the concept known as Vega.
Like Delta, which measures the sensitivity of an option to changes in the underlying price, Vega is a risk measure of the sensitivity of an option price to changes in volatility. Since both can be working at the same time, the two can have a combined impact that works counter to each or in concert. Therefore, to fully understand what you might be getting into when establishing an option position, both a Delta and Vega assessment are required. Here Vega is explored, with the important ceteris paribus assumption (other things remaining the same) throughout for simplification.
Vega and the Greeks
Vega, just like the other “Greeks” (Delta, Theta, Rho, Gamma) tells us about the risk from the perspective of volatility. Traders refer to options positions as either “long” volatility or “short” volatility (of course it is possible to be “flat” volatility as well). The terms long and short here refer to the same relationship pattern when speaking of being long or short a stock or an option. That is, if volatility rises and you are short volatility, you will experience losses, ceteris paribus, and if volatility falls, you will have immediate unrealized gains. Likewise, if you are long volatility when implied volatility rises, you will experience unrealized gains, while if it falls, losses will be the result (again, ceteris paribus).
Volatility works its way through every strategy. Implied volatility and historical volatility can gyrate significantly and quickly, and can move above or below an average or “normal” level, and then eventually revert to the mean.
Let’s take some examples to make this more concrete. Beginning with simply buying calls and puts, the Vega dimension can be illuminated. Figures 9 and 10 provide a summary of the Vega sign (negative for short volatility and positive for long volatility) for all outright options positions and many complex strategies.
The long call and the long put have positive Vega (are long volatility) and the short call and short put positions have a negative Vega (are short volatility). To understand why this is, recall that volatility is an input into the pricing model – the higher the volatility, the greater the price because the probability of the stock moving greater distances in the life of the option increases and with it the probability of success for the buyer. This results in option prices gaining in value to incorporate the new risk-reward. Think of the seller of the option – he or she would want to charge more if the seller’s risk increased with the rise in volatility (likelihood of larger price moves in the future).
Therefore, if volatility declines, prices should be lower. When you own a call or a put (meaning you bought the option) and volatility declines, the price of the option will decline. This is clearly not beneficial and, as seen in Figure 9, results in a loss for long calls and puts. On the other hand, short call and short put traders would experience a gain from the decline in volatility. Volatility will have an immediate impact, and the size of the price decline or gains will depend on the size of Vega. So far we have only spoken of the sign (negative or positive), but the magnitude of Vega will determine the amount of gain and loss. What determines the size of Vega on a short and long call or put?
The easy answer is the size of the premium on the option: The higher the price, the larger the Vega. This means that as you go farther out in time (imagine LEAPS options), the Vega values can get very large and pose significant risk or reward should volatility make a change. For example, if you buy a LEAPS call option on a stock that was making a market bottom and the desired price rebound takes place, the volatility levels will typically decline sharply (see Figure 11 for this relationship on S&P 500 stock index, which reflects the same for many big cap stocks), and with it the option premium.
Figure 11 presents weekly price bars for the S&P 500 alongside levels of implied and historical volatility. Here it is possible to see how price and volatility relate to each other. Typical of most big cap stocks that mimic the market, when price declines, volatility rises and vice versa. This relationship is important to incorporate into strategy analysis given the relationships pointed out in Figure 9 and Figure 10. For example, at the bottom of a selloff, you would not want to be establishing a long strangle, backspread or other positive Vega trade, because a market rebound will pose a problem resulting from collapsing volatility.
This segment outlines the essential parameters of volatility risk in popular option strategies and explains why applying the right strategy in terms of Vega is important for many big cap stocks. While there are exceptions to the price-volatility relationship evident in stock indexes like the S&P 500 and many of the stocks that comprise that index, this is a solid foundation to begin to explore other types of relationships, a topic to which we will return in a later segment.
Go to Part 7 – Option Volatility: Vertical Skews and Horizontal Skews