Option Volatility: Strategies and Volatility

Inexperienced traders tend to overlook volatility when establishing an option position. In order for these traders to get a handle on the relationship between volatility and most options strategies, it’s essential to understand the concept known as Vega.

Vega is a risk measure of the sensitivity of an option price to changes in volatility. It is somewhat akin to Delta, which measures the sensitivity of an option to changes in the underlying price. Both Vega and Delta can work at the same time, and they can have a combined impact which either works counter to one another or in concert. Thus, in order to fully understand your option position, it’s necessary to assess both Delta and Vega. In this tutorial chapter, we’ll explore Vega, with the ceteris paribus assumption throughout for simplification.

Vega and the Greeks

All of the Greeks, including Delta, Theta, Rho, Gamma, and Vega, tell us about the risk from the perspective of volatility. Options positions can either be “long” volatility or “short” volatility (it’s also possible to be “flat” volatility as well). In this case, long and short are terms referring to the same relationship pattern as long and short in a stock position. That is, if volatility increases and you are short volatility, you’ll experience losses, ceteris paribus, and if volatility declines, you’ll have immediate unrealized gains. Conversely, if you are long volatility and implied volatility rises, you’ll experience unrealized gains, while declining IV will result in losses. (For more on these factors see, Getting to Know The "Greeks".)

Volatility is key to every strategy. Because both IV and historical volatility can fluctuate rapidly and significantly, they can have a major impact on options trading.

We’ll explore some examples to put this in real-world terms. First, let’s examine Vega through the examples of buying calls and puts. Figures 1 and 2 provide a summary of the Vega sign (negative for short volatility and positive for long volatility) for all outright options positions and for many complex strategies.

Both the long call and the long put have positive Vega, meaning that they are long volatility, while the short call and short put positions have negative Vega (meaning they are short volatility). This refers back to the fact that volatility is an input into the pricing model, and the higher the volatility, the greater the price, because the probability of the stock moving greater distances in the life of the option increases, as does the probability of success for the buyer. Thus, option prices gain in value to incorporate the new risk-reward. If you imagine the seller of the option in this case, it makes sense: he or she would want to charge more if the seller’s risk increased with the rise in volatility

At the same time, if volatility declines, the prices should be lower. When you own a call or a put and volatility declines, the price of the option will also decline. Of course, this is not beneficial, and it will result in a loss for long calls and puts (see Figure 1). On the other hand, though, short call and short put traders would experience a gain from a decline in volatility. Volatility will have an immediate impact, and the size of the decline or gains in price is dependent upon the size of Vega. Up to this point, we’ve seen that the sign (negative or positive) of Vega implies changes in the price. The magnitude of Vega is also important, as it determines the amount of gain and loss. So what determines the size of Vega on a short and long call or put?

Put simply, the size of the premium on the option is the source. The higher the price, the larger the Vega will be. Thus, as you go farther out in time, the Vega values can get increasingly large, eventually posing a significant risk or reward should volatility change. As an example, if you buy a LEAPS call option on a stock that was bottoming out, and then the desired price rebound takes place, the volatility levels will usually decline sharply (Figure 3 shows this relationship on the S&P 500 index), and along with it the option premium will decline as well.

Generated by OptionsVue 5 Options Analysis Software.

Figure 3: S&P 500 weekly price and volatility charts. Yellow bars highlight areas of falling prices and rising implied and historical. Blue colored bars highlight areas of rising prices and falling implied volatility.

Figure 3 shows weekly price bars for the S&P 500 alongside levels of implied and historical volatility. In this chart, we can see how price and volatility relate to one another. Most big cap stocks mimic the market; when price declines, volatility rises, and vice versa. This relationship is important to incorporate into strategy analysis because of the relationships pointed out in the previous two charts. As an example, at the bottom of a selloff, you would not want to establish a long strangle, backspread, or other positive Vega trade, as a market rebound would pose a problem because of declining volatility.

The Bottom Line

In this chapter, we’ve looked at the essential parameters of volatility risk in popular option strategies. We’ve also examined why Vega is important to consider as well. Of course, there are exceptions to the price-volatility relationship evident in indexes like the S&P 500, but this is nonetheless a solid foundation from which to explore other types of relationships. Next up, we’ll look at vertical and horizontal skews.