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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.
Figure 1: Outright options positions, Vega signs and profit and loss (ceteris
paribus).
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
Figure 2: Complex options positions, Vega signs and profit and loss (ceteris
paribus).
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.
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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.
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