Vega: Volatility's Kissing Cousin

04/22/2014 8:00 am EST

Focus: OPTIONS

Steve Smith

Reporter (Options Columnist), Minyanville

With volatility rising and earnings season heating up, it's the perfect time to look at vega—volatility's kissing cousin, writes Steve Smith of Minyanville.com.

Options traders sometimes use vega and volatility interchangeably, and while they are related, they're two distinct concepts.

Volatility is one of the five inputs used in the basic Black-Scholes options pricing model. Higher volatility means higher option prices. That's because higher volatility means greater expected price swings.

High-beta stocks such as Netflix (NFLX) and Facebook (FB) have higher volatility readings and, therefore, more expensive options than more mature and stable companies such as Apple (AAPL) and JPMorgan Chase (JPM).

Take a look at this table:

chart
Click to Enlarge

Despite Apple having a higher underlying stock price than Netflix, its at-the-money May call is actually much lower in price than Netflix. The Netflix call costs 7.8% of its stock price, while Apple's is just 3.0%.

And note that both JPMorgan and Facebook are trading around $60, but the latter's call is nearly five times the price. This is almost entirely due to differences in implied volatility (which is because Facebook is far more likely to make a huge move than JPMorgan). Last quarter provided a perfect example of this. Facebook rose 14% in one day after reporting earnings; JPMorgan moved just 0.1%.

Understanding the difference between historical (or realized) volatility and implied volatility (IV) is crucial in determining whether an option is relatively "cheap" or "expensive," and whether you want to be long or short vega. Vega isolates how a change in implied volatility will impact an option's price by estimating how much its value changes when implied volatility moves 1%.

The JPMorgan May $60 call is $1, with a vega of 0.07. If implied volatility were to move from 19% to 20%, the theoretical value of the call would increase to $1.07. If IV declined by 1% to 18%, the call's value would drop to $0.93. This could occur without any change in the price of the underlying shares or realized volatility.

Getting long vega means your position will benefit from a rise in implied volatility. For example, all things being equal, a long call or put position benefits from an increase in implied volatility.

In general, being short vega is a more dangerous approach. Being short vega, like being short call options without a hedge, carries unlimited theoretical downside risk.

Now let's look at a chart plotting vega against time to expiration:

chart
Click to Enlarge

Vega is highest for at-the-money strikes and increases as you go out in time. Notice also that peak vega also moves slightly out-of-the-money as you go out in time. This is because the probability of a given price move occurring increases as the time frame is extended.

For example, if you're speculating on a $10 price move, you have more of a chance of being right if you have a six-month time frame rather than a one-month time frame.

A directional calendar spread, in which one buys a later-dated out-of-the-money option and sells a near-term out-of-the-money option is one strategy that tries to benefit from this concept. 

When it comes to known events such as earnings reports, implied volatility will typically rise ahead of news and decline afterward.

In this case, one might want to be short vega through the sale of a straddle or iron condor, which would benefit from a decline in implied volatility even if the stock moves sharply following the news event.

Conclusion
Understanding what the options market is expecting, or "pricing in" as measured by implied volatility, will help you determine just how large a price move will be needed for a profit when you are long options. And vega will tell you how much a change in implied volatility following the report will impact the price of the options.

Often, a decline in IV (also known as vega risk) will offset the impact of price gains in the underlying stock. This is how you can be correct on a stock's direction and still lose money on an options position.

It's a good idea to use a basic options calculator like this one from the Chicago Board Options Exchange (CBOE) to play around with changes in implied volatility over different time frames and see what the impact on the option's price will be.

By Steve Smith, Contributor, Minyanville

Related Articles on OPTIONS