Options trading part 5: Vega/Volatility risk
Vega, commonly known as the “volatility” of an option contract, is our fourth risk consideration while trading options & delta-hedging.
Vega is the options greek that measures the sensitivity of an option’s price to a change in “implied volatility”.
In the same way, as option contract values are impacted by changes in the underlying price (“delta”) and the passage of time (“time decay/“theta”), they are also affected by changes in the underlying contract’s volatility.
You have learned in school, on television, or on YouTube how to visualize atoms, protons, neutrons, electrons, etc.
This model is entirely inaccurate, yet we use it because it helps us visualize the specifics of these abstract subjects.
Consider everything in this article to be an oversimplification to assist you with more advanced reading about options trading
The price of an option depends on
- the underlying asset’s price
- the strike price
- the time to expiration
- interest rates.
Professional options traders, hedge funds, market makers, dealers, quant firms, etc have pricing models to value option contracts.
Volatility is one of the inputs that professional options traders use in models to price an option.
Their models help them generate a distribution of prices for the underlying contract, which in turn helps to value option contracts.
That’s because the volatility of an asset is one of the main factors determining an option's price. Therefore, by having a model that considers volatility, market makers can get a better idea of an option's price.
Volatility is a key factor in options pricing, and by extension, in trading options. If you can model volatility accurately, you can get a better sense of or determine the price of an option contract.
However, if you, as a market maker, use the wrong volatility in your model, the price distribution will be inaccurate. That means you as a market maker could end up over-or under-pricing option contracts, which could lead to losses.
By “models”, I mean the equations and calculations that traders use to predict the price of an option. These “models” take into account a variety of factors, including volatility, in order to come up with a price prediction.
(I’m not talking about women who are “models”… Just to clear out any potential confusion... In this context)
If vega is positive, then the option’s price will increase as volatility increases.
If vega is negative, then the option’s price will decrease as volatility increases.
Retail traders like you and I aren’t in the business of predicting volatility. Not all firms are all in the business of forecasting volatility accurately.
Instead of trying to predict or model volatility, options traders often refer to “implied volatility” to gauge what the market currently believes volatility to be.
We assume the market knows better than we do. It’s difficult to outperform the market and forecast volatility better than the “implied volatility” because the market is more efficient than any one actor.
An option contract’s market price represents the cumulative input of many diverse market participants, each with their subjective valuation. As a result, the market price is more likely to reflect the true value of an option contract than any individual’s perspective.
The Black-Scholes model
We can use the “Black-Scholes model” to determine the fair value of options contracts. The Black-Scholes pricing model requires 5 or 6 (if dividend) different inputs for the price of a given option
We covered the inputs of the Black-Scholes pricing model in part 1 of this options trading series.
- price of the underlying asset
- the strike price
- the time to expiration
- the interest rate
- implied volatility
With these inputs, we can calculate the fair value of an option contract by using a Black-Scholes model value calculator.
However, if we don’t know the “ implied volatility,” but we do know the first 4 inputs and the price of the option contract, we can solve for the fifth input (implied volatility) using a process called “backing out.”
That process allows calculating what the market is “implying” about the underlying asset's volatility based on the option's current price.
This implied volatility is then used as an input into the Black-Scholes model to determine the fair value of the option.
If you remember part 1 of the options trading article series
Although we refer to “implied volatility” as an input variable in the Black-Scholes model, it is actually a calculated output variable.
Implied volatility, often known as “IV,” is an essential component of the Black-Scholes model, which affects the price of options contracts.
In contrast, IV is a computed output variable depending on the current market price of the underlying item.
Therefore, even though “implied volatility” (IV) is used as an input in the Black-Scholes model, it is ultimately an output variable.
A standard deviation (σ) is a way to measure how spread out the data is in relation to the mean.
A low standard deviation indicates that most of the data are concentrated around the mean, while a high standard deviation indicates that the data are more dispersed.
A standard deviation close to zero means that the data points are relative to the mean, while a high or low standard deviation means that the data points are above or below the mean.
Implied volatility absolute cheapness or expensive of an option
The “Implied volatility” is the market’s expectation of the future volatility of the underlying. It’s important to understand because it greatly impacts the price of options. The higher the implied volatility, the higher the cost of the options.
When we say an option is “cheap” or “expensive,” we are referring to its “implied volatility”.
The “Implied volatility” measures the expected volatility.
- The higher the implied volatility, the more expensive the option contract will be.
- The lower the “implied volatility”, the cheaper the option contract is.
Several factors can affect the implied volatility of an option.
If there is an abundance of anticipated news, this will tend to increase “implied volatility” and, therefore, the option's price increases which could make an option contract not as profitable as expected or even lead to a loss.
Conversely, if there is very little news or buying activity, the market expects relatively little volatility and will price the option contracts accordingly. As an analyst or options trader, it is important to be aware of the factors that can affect the implied volatility of an option.
That will allow you to assess better whether an option is cheap or expensive relative to its historical volatility.
For example, traders who bought “put options” for GameStock lost money because the implied volatility was high, meaning the put option contracts were expensive.
The market expected the price of GameStock to drop, so those “put options” were too expensive.
So even for directional bets, the “implied volatility” is important, considering the crash of GameStock was already “priced in.”
This leads us to our next topic: “IV Crush”
Implied volatility crush (IV crush)
High implied volatility occurs when traders are uncertain whether prices will rise or fall, and implied volatility increases.
When traders are uncertain about the direction in which the prices will go. Possibly before news releases, and they are more likely to buy options because they expect more volatility.
If the expected move either up or down with magnitude doesn’t occur, it can “crush” the other side’s volatility expectation.
Several examples are bitcoin and the expected news of El Salvador. Market participants expected the news, which drove up the “implied volatility” or “expected volatility” which drives up the price of options contracts.
Or Ethereum 2.0 and “ultra sound” money, the merge, and other news events.
That’s what we mean by the “news is already priced in” because it is due to options contracts, to a certain extent. The market already priced in that expected move with “implied volatility”
So you can’t make money on news events? Sure you can. If the market is pricing in that a 20% move up can happen with an 80% probability, which makes the option more expensive while you think the probability is 70%, why even buy that option contract if it’s already priced for an 80% probability?
You’re just giving away money to a hedge fund manager whine collection or vacation home.
However, if you think the market can move up more than 20% with a 90% probability because of different reasons, then maybe it’s worth the shot. Just be aware that all news events are “priced-in” to a certain extent.
Volatility Rule of 16 & 19
The greek symbol denotes volatility: σ
The textbook definition of volatility is the standard deviation annualized. Volatility measures that, and the “rule of 16” is used to convert from daily to annualized and annualized to daily.
The rule of 16 is a shortcut used to convert between daily and annualized volatility.
To convert from daily to annualized volatility, you multiply the daily volatility by the square root of 16.
To convert from annualized to daily volatility, you divide the annualized volatility by the square root of 16.
The VIX index is a measure of implied volatility in the S&P500
Here we can see the chart of the VIX, which is currently at 26. We can use the rule of 16 to know the implied volatility for one day
26 / 16 = 1.625%
The current VIX index is 26, which using the rule of 16, suggests a 1.625% daily move that the market has already priced in.
The rule of 16 states that you should take the square root of the number of business days in a year, typically 252 for equity markets.
Now for the cryptocurrency markets, which are open daily, you should take the square root of the number of days in a year which is 365
That is a 19% annualized volatility.
Realized volatility is a “lagging indicator” that informs us what has already happened in the market rather than what we expect in the future. However, we can use it to determine the current state of the market.
Lagging indicators are those that show the direction of a trend after it has already started. That is different from leading indicators, which show what will happen in the future.
Realized volatility is a lagging indicator because it only shows us what happened in the market in the past. It doesn’t tell us anything about what will happen in the future.
The thing about Realized volatility is that you can calculate it for a variety of backward-looking samples. We can look at the 7-day realized volatility, 30-days realized volatility, or look back at 365-day realized volatility.
Each of them will give you a different number and shows you slightly differently.
The options market is driven by market participants' willingness to speculate on market movements or hedge their positions. That speculation or desire to hedge affects supply and demand and drives up or down the price of options contracts, which drives up or down the levels of “implied volatility.”
When demand for options contracts is high, prices increase, and implied volatility levels increase.
However, when market participants are less willing to speculate or hedge, prices for options contracts fall, and implied volatility decreases.
Therefore, the buying and selling pressure on options contracts drives changes in prices and implied volatility levels.
“Vega” is the option contract greek that measures the exposure of the contract to changes in implied volatility.
Vega is the change in an option contract value when implied volatility goes up by 1% or 1 “vol point.” So, vega measures how sensitive an option’s value is to changes in “implied volatility.”
If an option has a vega of 0.5, its value will increase by $0.50 for every 1% increase in implied volatility.
Remember, as mentioned before
“implied volatility” refers to the market’s expectations of future “realized volatility.”
In other words, it measures how volatile the market thinks or expects the underlying asset will be in the future.
The demand or supply for option contracts determines if market participants are “long-gamma” or “short-gamma.”
“Long-gamma” means that the market participant is betting on the security becoming more volatile.
While “short-gamma” means that the market participant is betting on the security becoming less volatile.
These bets on predicting volatility can eventually impact the underlying asset “realized volatility”.’
The Vega exposure of a position measures how sensitive the value is of a position to changes in the implied volatility.
That’s different from “gamma” and “theta” exposure, which measure how sensitive the value of the position is to actual “changes” in the underlying asset’s price or “realized volatility” with respect to the passage of time and magnitude of a move.
The vega of an option contract is a measure of the amount of profit or loss associated with changes in “implied volatility.”
When the market “expectation” of volatility changes (implied volatility), so will the option’s vega, resulting in a change in the option holder’s profit or loss.
For example, if an options contract has a Vega of 0.20, that means that for every 1% change in “implied volatility,” the contract will gain or lose $0.20 in value.
So, if the “implied volatility ”increases by 3%, the option’s value will increase by $0.60. Conversely, if the “implied volatility” decreases by 2%, the option’s value will decrease by $0.40.
If you buy an option contract, you’re
- long gamma
- short theta (you’re paying time decay)
- long volatility (exposure to realized volatility)
If the market moves more (higher realized volatility) than the current “implied volatility” is pricing in, you will make money from the realized volatility.
However, your theta (time decay which you’re paying) is determined by the “implied volatility”. So you need to make more from the market movement than you pay in “time decay” to be profitable.
What’s the difference between implied volatility and realized volatility?
- “implied volatility”
- “realized volatility”
can sometimes move in opposite directions!
“Implied volatility” is a measure of the expectation from the market of how volatile the market will be in the future.
In contrast, “realized volatility” is a measure of how volatile the market currently is.
Sometimes, the market expects or implies more volatility than the realized volatility ends up being. In these cases, “implied volatility” will be higher than “realized volatility”.
However, there can also be times when the market expects less volatility, in these cases, “implied volatility” will be lower than “realized volatility”.
So, suppose “implied volatility” is going down even though “realized volatility” is going up.
That might catch you off guard since it indicates that you could gain money from “realized volatility” and lose money from “implied volatility.”
So that’ when we trade multiple option positions, we need to understand how the different option greeks interact to gauge whether our positions are working or not.
Option Greeks can work together or in opposition to each other, so it’s important to be aware of these relationships.
In this screenshot, I have 12 outstanding options positions, some of which are calls and some of which are puts. Some of the calls are shorted, and some of the puts are shorted. Additionally, I bought some calls and bought some puts. Additionally, there is 1 future short position to hedge the BTC collateral on Deribit. The combined greeks are represented in the screenshot.
You can see the greeks combined over all my option positions, including 1 future position to hedge out my BTC collateral on Deribit.
What is my vega when I buy an option contract?
Remember, an option contract derives its value from the “intrinsic value” and the “time value.”
When you buy an option contract, you’re long vega.
That’s because “implied volatility” impacts the “time value” of an option contract.
An increase in “implied volatility” results in an increase in “time value” for the options contract—consequently, the value of the options contract increases.
An increase in “implied volatility” results in an increase in “time value” of the option contract — consequently, the value of the options contract increases since there is a greater chance that the price of the underlying asset will swing “in the money” (ITM).
A decrease in “implied volatility” suggests that the market predicts less movement in the underlying asset, which reduces “time value.”
That reduction in “time value” indicates that less likelihood or time is remaining for the options contract to move enough for it to expire “in the money” and become worthless.
If you are long an option, you have vega exposure
Vega for longer-dated options vs shorter-dated options
The longer-dated the option contract, the more vega it has.
Each “vol point” has more value for a longer-dated option than a short-dated option contract.
Therefore, if volatility decreases, your option contract will lose more value per “vol point” than if you were for a short-dated option contract.
That should make sense.
Remember The “time value” of an option contract also refers to the amount of time remaining until the contract expires.
A 1-day option contract, for example, doesn’t have much “time value” because there isn’t much chance the option contract would swing “in the money” within such a short period.
Therefore, if the option contract were to drop by a few “vol points,” this would only represent a slight loss of time value (since there’s not much time left anyway) and wouldn’t significantly impact the option’s price.
Remember, The longer the time remaining, the higher the “time value”. Therefore, a 3-month option contract will have more time value than a 1-day option contract.
A 3-month option contract has a lot of time value. Each vol point you go down will decrease the value of the option contract by a large amount for each reduced vol point.
The longer-dated an option is, the greater its Vega exposure will be. That’s because a longer-dated option has a greater chance of being impacted by a change in volatility than a shorter-dated option.
In the previous article, we covered “Gamma/Curvatature risk” and visualized how the gamma of an option contract looks like a bell shape.
Options trading part 3: Gamma/curvature risk
Gamma, often known as the option’s “curvature risk,” is our second risk consideration for trading options and delta…
As mentioned before
to determine the value of an options contract, we have to look at the “implied volatility,” which impacts the option contract’s “time value.”
Remember, the “implied volatility” is the estimated volatility by the market over the life of the options contract.
The higher the implied volatility, the higher the “time value” of the contract (i.e., the option contract is more expensive)
Therefore, when analyzing the value of an options contract, we have to look at the current level of implied volatility to determine how it might impact the contract’s price.
We know that an option’s maximum “time value” is at the “strike price.” Therefore, the “vega exposure” should also be highest when the option is at the “strike price” because that is where there is the most “time value.”
Vega is a measure of an option’s price sensitivity to changes in implied volatility.
- An option contract with a higher vega will experience greater price changes than an option with a lower vega, all else equal.
- Therefore, an option with a higher vega will be more sensitive to changes in the underlying asset’s volatility than an option with a lower vega.
Now, the “vega” of an option contract is also a bell shape centered around the “strike price,” just like “gamma.”
The vega of a 60-day option contract is highest at the strike price and diminishes as you move away from the “strike price” in either direction.
However, the entire vega profile shifts downward over time and gets closer to zero.
The “vega” of an option declines as the option approaches expiration.
The “vega” is highest at the option’s “strike price” because of the “time value” associated with the option contract.
You can see the 60 days, 50 days, and 40 days. However, the absolute amount of “vega” declines as expiration nears.
The vega exposure represents the change in the option price for a 1% change in implied volatility. If the market is fearful, the vega exposure will be positive, meaning the option price will increase. If the market is not fearful, the vega exposure will be negative, meaning the option price will decrease.
A “long vega” position would profit from an increase in volatility, while a “short vega” position would profit from a decrease in volatility.
We might want to be “long vega” if the market becomes more fearful in the future. That would lead to an increase in “implied volatility” since there’s an expectation from the market that volatility will be higher.,
We want to be “short vega” if we expect the market to become less fearful in the future or expect less volatility. That would lead to a decrease in “implied volatility,” which would be profitable.
When you buy an option contract, you will have “long vega” exposure, meaning that you will benefit from an increase in “implied volatility.”
When you short-sell an option contract, you will have “short vega” exposure, meaning that you will benefit from a decrease in volatility.
If you wonder why looking at “vega” is so important for options trading & you might have read my FTX MOVE article
FTX.com MOVE contracts
MOVE contracts are a straddle where the strike price is determined at the first hour of the day and expires at the last…
Here’s the Vega graph of this weekly FTX MOVE contract. I bought it last week when it was still labeled as a “NEXT WEEK MOVE” contract.
FTX 10% Fee Discount
My referral link will give you a 10% discount instead of the usual 5% discount for anyone who wishes to give it a go.
Deribit is the largest cryptocurrency exchange for trading options. Deribit has European-style cash-settled options.
Deribit offers European-style cash-settled options.
If you want to trade bitcoin options, your collateral will consist of BTC. Similarly, your Ethereum collateral will be in ETH and Solana.
Due to the need to hedge your risk, it’s not the best platform for beginning options trading. Remember trading on Bitmex with Bitcoin collateral.
Trading platform: Delta exchange
Another new exchange called “Delta exchange” has options trading for multiple altcoins. You could use these options to hedge your portfolio for altcoins. Here we can see the options chain for Avax.
The fact that your collateral will be stablecoins rather than BTC or ETH is an additional incentive to favor Delta Exchange over Deribit, in addition to the availability of altcoin trading choices.
If you are new to options trading, I recommend Delta Exchange and ByBit over Deribit. After learning how to hedge your collateral on Deribit, you can use Deribit.
If you’re seeking to signup and want a 10% discount
You can use my referral link
They also have a great tool to model your options position.
It’s a great alternative if you can’t acquire access to Deribit due to your location.
ByBit recently offers options trading for bitcoin & ethereum. If you are trading on ByBit, you can use options to hedge with options.
Options trading on ByBit is much easier than on Deribit. That would be simpler for beginners.
Why, you may wonder? When trading on Deribit, your collateral is in BTC, but on ByBit it is held in USDC.
When new traders join Deribit, they typically forget that their collateral is in BTC, resulting in incorrect hedges and computations.
As some of you may recall, trading on Bitmex with 1x leverage is equivalent to 2x leverage since your collateral already exposes you to 1x leverage.
ByBit Options (Discount on fees and $100 deposit bonus): https://www.bybit.com/register?affiliate_id=6776&group_id=1653&group_type=1
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Part 6 of options trading will be released soon
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If you liked this article, you will probably also love this article about FTX MOVE contracts.