Options trading part 5: Vega/Volatility risk

Vega introduction by CME group

Disclaimer:

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

Volatility model

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.

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.

The Black-Scholes model

Black-Scholes Model Value Calculator
Implied volatility calculator

Therefore, even though “implied volatility” (IV) is used as an input in the Black-Scholes model, it is ultimately an output variable.

standard deviation

standard deviation

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.

Implied volatility crush (IV crush)

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.

Volatility Rule of 16 & 19

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.

VIX
26 / 16 = 1.625%

Realized Volatility

bitcoin realized volatility for 7-day, 30-day, and 365-day

Vega

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.

“Vega” is the option contract greek that measures the exposure of the contract 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.

“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”.’

What’s the difference between implied volatility and realized volatility?

Deribit total position

What is my vega when I buy 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.

Vega for longer-dated options vs shorter-dated options

The longer-dated the option contract, the more vega it has.

Remember The “time value” of an option contract also refers to the amount of time remaining until the contract expires.

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.

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.

Vega Visualized

Gamma graph of an option

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)

However, the entire vega profile shifts downward over time and gets closer to zero.

A “long vega” position would profit from an increase in volatility, while a “short vega” position would profit from a decrease in volatility.

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.

Click to zoom in
Vega FTX Weekly MOVE contract
FTX Move contract- long vega exposure

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Final words

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