What Does Negative Vega Mean for Credit Spreads?

04/27/2015 8:00 am EST

Focus: OPTIONS

To best answer this question, the staff at Investopedia.com highlights, specifically, how Greek vega relates to the credit spread option strategy and cites an example of an option trade using a hypothetical underlying asset for support.

Greek vega measures an option's sensitivity with respect to a change in the underlying asset's volatility. The vega of an option represents the amount the option's value changes when there is a 1% change in the underlying asset's volatility. Therefore, when an underlying security's volatility increases, the option on the underlying security increases and the opposite is true. When a position is net short, like a credit spread, the vega of the position is negative.

A credit spread is used as an option strategy that involves purchasing one option and writing another option in the same underlying asset and expiration date. However, the strike prices are different. Since a credit spread is a net short position and has negative vegas, it indicates that the position decreases in value when the underlying asset's volatility increases. Conversely, it increases in value when the underlying asset's volatility decreases.

For example, say an investor wants to open a credit spread position in stock XYZ using call options while the underlying asset's volatility is 30%. She buys one June call option with a strike price of $25 and a vega of +0.09 for $1. Simultaneously, she writes one June call option with a strike price of $20 and a vega of -0.30 for $4. Therefore, the vega of the overall position is -0.21. If XYZ's volatility increases to 31%, the long call option gains 0.09, while the short call option loses 0.30. The overall position loss for a one point increase in volatility is $21, or 0.21*100.

By the staff at Investopedia.com

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