Options trading part 9: Weighted Vega & trading the term structure

The “weighted Vega exposure” lets us quantify our options position with different maturities into a single figure that reflects our total exposure to implied volatility for our options contracts with different maturities. There are opportunities for volatility traders to trade the term structure.

Maturity of an option contract and implied volatility

The maturity of an option contract refers to the time left until the option expires.

Due to variables such as the underlying asset’s volatility and the market’s anticipation of where the underlying asset’s price will be at the option’s expiry, options with various maturities may exhibit vastly different behaviors.

For instance, if the underlying asset is very volatile, options with shorter maturities often have greater implied volatilities than options with longer maturities.

That is because there’s more uncertainty in the shorter period; therefore, investors will seek a greater premium (i.e., higher implied volatility) for options that expire in the shorter term.

Similarly, suppose the market anticipates that an asset’s price will rise in the future. In that case, options with longer-dated maturities will often have greater implied volatilities than options with shorter-dated maturities.

That is because the asset’s price has more time to go up (or down) to its predicted level. Therefore, market participants will demand a larger premium for options that expire farther in the future.

A 1-year option’s implied volatility may trade within a narrower range than a 1-month option’s significantly greater range.

Vega

As a fresh reminder, let’s review the options greek “vega” again.

The option geek “vega” refers to the amount by which the price of an option changes in response to a 1% change in the underlying asset’s volatility. It…