Implied Volatility Part II, Applying Vega.

Not too much longer before we can kiss the "dog days of summer" goodbye, and start getting into the year end rally. Keep patient, a good atmosphere is right around the corner. For now I want to leave you with a little educational "nugget" before we close out a relatively good week.

Back to the topic we discussed yesterday about implied volatility...I talk a lot about my preference to trade OTM options over ITM options because OTM's are more sensitive to changes in implied volatility. This is where vega comes into play. Let me define it and how to apply it.

Vega measures the sensitivity of the price of an option to changes in volatility. A change in volatility will affect both calls and puts the same way. An increase in volatility will increase the prices of all the options on an asset, and a decrease in volatility causes all the options to decrease in value. However, each individual option has its own Vega and will react to volatility changes a bit differently. The impact of volatility changes is greater for out-the-money options than it is for in-the-money options. While Vega affects calls and puts similarly, it does seem to affect calls more than puts. Perhaps because of the anticipation of market growth over time.

I trade OTM options because if I am able to take this option and watch it become at-money(or ITM), then I see a big change in time value, which is represented by vega. Many of my trades are based on profiting on price movement AND a volatility movement. If you are expecting a big upswing in volatility, trade an option with a more sensitive vega and you will be smiling all the way to the bank. If you want an option that is dull to the effects of volatility, trade ITM. Simple as that!

Next week I will show you a more constructive approach to this. I want to introduce the volatility skew to you. It will be helpful to see this and how time decay can actually be reversed...meaning you can actually make your time value grow!

I want to keep expanding on this topic. This post here was somewhat generic. We will continue to chip away at this until we all feel more in control of how to select the proper option for our analysis. When you know all the"in's and out's" it will be so much easier to select the right vehicle. More profitable too!

Thanks for all your efforts this week. The activity is increasing, and keep continuing to do your part. I also want to credit one of our members for this awesome photo he created of me. (This was based on a comment that was left about who I supposedly look like.) Striking resemblance!!! Keith, if things don't work out in trading, I will hire you as a graphic designer for this blog! You have a gift, thanks for sharing!

As always, get out there and have a relaxing weekend. Leave the emotion and the stress behind, and do something you enjoy. I will likely play a little golf tomorrow, and take my kids up the canyon to the Provo river on Sunday. My boy loves to "throw rocks in river!" If you can... attend my session Monday morning and ask lots of questions. There are a lot of details to uncover on option pricing. Thanks for staying in touch, have a great weekend.

Jeff

Where do you find the numbers for vega? In the option greeks I've only seen delta,gamma theta.

Use the black-scholes calculator. Input your figures, and calculate everything. It will give you the theoretical vega of your option. Better pricing data is on the way with the new toolbox release!

Glad you enjoyed the picture…. I can’t take credit for creating it though…I discovered it on the web!

I received the book yesterday, “Trading in the Zone”. Can’t wait to get into it. My plan is to read it on vacation in two weeks....but, I have a feeling I will be half way through it by then!!

Thanks again for all your efforts.

Keith

Jeff,
After reading this vega post I watched your demo on pricing. THANK YOU! Now I understand why one of my trades is dead in the water while another is swinging like a pendulum on crack.

But here is my question - you mentioned that there is a way to check if IV is anticipated to rise or fall before you enter a trade. Where and how do we do this? Is there a chart? And another question - is the volatility of a stock at all related to IV of an option?

Thanks again. For everything.

Karen

LoL, you go jar jar!

Jeff, where did you get that JavaCharts Beta Charting software?

Great post Jeff. Very interesting to see how much influence IV has on option pricing.

thanks,
raj

PS: another place to find out Vega is optionsXpress(If you use them to trade). They have it on each option (when you click to see the details)

Jeff,
Just wanted to send you a huge THANK YOU, for the information you share and your gifted teaching style. You have definitely accelerated my learning curve. May GOD bless you and your family for your dedication to helping and teaching others. We need more positive thinking and acting people, like you, in this world.
Thanks again,
Jeff Tighe, from Indiana, a true basketball loving state.

Jeff, where can we access your class on option pricing ? Is this a webinar and available under Trading Rooms ? And thank you very much for sharing your expertise with us , You ROCK !!!!

JR,

You can access Jeff's Option Greeks and Volatility Trading Room under the Debit Spreads section of the Advanced Options Trading Rooms.

SK

Excellent blog site and articles.
I now understand why the prices on Index options have settled (very low IV). Am I reading this correctly that I should wait for IV to increase before I do Credit Spreads.

Jedi er a Jeff, if you like being long VEGA, buy ATM. ATM longer dated have the greatest sensitivity to the IV.

Credit spreads give a trader little or no advantage over IV. It neutralizes the effect and thats about it. Debit spreads do the same thing.

Deltatrader

if the IV is high then the option would be priced higher and hence would it not give you more value for your credit spread. I guess it would work more if leg in i-e sell at high IV and buy at low (or lower) IV.

Jeff,
Thank you for sharing the info on vega. I am looking forward to other education you can give us on this subject.
Hollye

Mahmood,

Legging into the spread would be optimal for taking advantage of higher IV, assuming the purchased option was bought when IV was lower and has now risen in value. But you might be smarter to just sell that bought option for a profit rather than spread. This depends on the time horizon for your trade.

If the bought and sold options were entered together, the only advantage would be if the sold option had a higher VEGA. If this were the case the spread would be net negative VEGA. But usually this is only by a few pennies if your expiration months are the same. You would then however have a theoretical advantage, which this a big priority when trading options.

Deltatrader

Jeff,

Review of your last master talk plus the comments here on IV and vega suggest a lot of folks would really benefit from a list of "Top Ten" ways to reduce option risk in a highly volatile market like we're in now.

I'm personally getting killed on my options with all the swings in price, especially ITM options. So ITM options provides little protection in my opinion.

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About me

  • I'm Option Addict
  • From Saratoga Springs, Utah, United States
  • I am a professional trader and an instructor for Investools. I've had relations with the markets for 9 years. Born in Concord, CA, but reside in Saratoga Springs, Utah. Father of THREE, Husband of one.
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