This is the fourth and final installment in a series about options Greeks on Market Insights.
So far we’ve reviewed three options “Greeks,” with memory tricks for keeping them straight:
Today our final Greek letter is Vega: V is for volatility.
Vega shows how much an option’s value changes based on movements in implied volatility, which expresses how much of a move the market expects from a stock. As a general rule, implied volatility increases before events like earnings, or when bearish things are happening. (Click here for our special report on trading implied volatility.)
Another general rule about vega is that it’s higher for longer-dated options. That’s not a surprise because the longer a contract’s lifespan, the more potential it has for big price swings before expiration.
As a result, vega tends to be the opposite from theta’s absolute value. Options with less time decay tend to more sensitive to changes in implied volatility.
Let’s return to the options chain for Apple (AAPL). Notice how the December 225 puts have 0.48 vega while the October 225s have 0.31 vega. That means if AAPL’s implied volatility rises 1 percentage point, the change will lift the premiums on the December contracts by $0.48 while the Octobers will gain $0.31.
Of course, it’s more complicated than that because of other Greeks like delta and gamma. Remember that implied volatility generally rises when a stock falls. So, in that case puts would also gain value based on delta (direction).
One common way to apply this is to think of vega as an extra kicker to the downside. When a selloff occurs, puts with more vega will profit from delta, gamma and vega.
There are also trade-offs because options with higher vega are longer-dated. That means they have more time value (extrinsic value) and are thus more expensive. They also have less gamma. Higher cost and lower gamma can mean less leverage — even when vega works in your favor.
Some traders use vega to hedge the overall market by owning long-dated puts on the SPDR S&P 500 ETF (SPY) that are also far out of the money. Delta will be very low and vega will be very high. That way they’ll profit from the volatility spiking if the market crashes. Meanwhile, the low delta will minimize their losses from upside in the market. And, their time decay (theta) is also low.
Finally, traders selling options need to know about vega: Volatility spikes like we saw in February can really hurt you. The reason is that being short options makes you effectively short vega. And being short vega essentially makes you short volatility. If you’re also short puts that makes you long delta (because puts have negative delta). Not fun when prices move lower!
In conclusion, vega may seem a little tricky because volatility can be an opaque concept. But options traders should have a basic understanding of how it works. Hopefully this post gets you started.