My previous post introduced the concept of “the Greeks” and their applicability to characterizing the response of an options position to changes in price of the underlying- the effects of delta and gamma. There remain two additional major Greeks used to help understand the impact of time and changes in implied volatility. These Greeks are theta and vega respectively.

Before beginning this discussion, I need to describe briefly the anatomy of an option price. Option market prices can be considered to be negotiated number that lies somewhere between the quoted bid and ask price. In reality this figure is the sum of two components; intrinsic and extrinsic (time) value. The intrinsic value is simply the amount of value attributable to an option by it being in-the-money. For example, AAPL currently is trading at around $337. I can buy a June 330 strike call, an in-the-money option, for about $11. Of the total premium paid, $7 is intrinsic and $4 is extrinsic or time value.

The amount of extrinsic premium embedded within the option price varies greatly amongst the available strike prices. Time premium is reliably the least in deep in-the-money options; the deeper in the money each individual option is, the less time premium it contains. At-the-money options always contain the most value of time premium. Extrinsic premium represents the entirety of the value of out-of-the-money options. Out-of-the-money options contain **no** intrinsic value.

When considering the impact of either theta or vega on the price of an option, it is important to realize that each of these variables impacts **only** the extrinsic portion of the total option premium. It is for this reason that traders who buy deep in-the-money options as surrogates for owning stock are generally little impacted by fluctuations in implied volatility because these options contain little if any embedded time premium.

Another potential point of confusion is the difference between implied volatility and vega. Implied volatility is a mathematically derived value which reflects the market opinion as to the magnitude of future price movement. Implied volatility values are dynamic and change over time as a result of the aggregate trader opinion as regards future price volatility of the underlying.

Vega measures the sensitivity of an individual option or option position to the changes in implied volatility. Vega is particularly helpful in more complex option positions consisting of combinations of several individual positions. In such positions, the response to changes in implied volatility is often not intuitively obvious. This “position vega” is calculated by simply adding the vegas of each individual option position.

For a given option, vega is always a positive number whether the option is a put or call. The trader who wants to construct negative vega positions must include short options for at least a portion of his total position.

In order to help understand the impact of vega on a position, let us consider the AMZN June 195 call. AMZN is currently trading at $194, so this 195 strike would be the current at-the-money series. This option is priced at $4.45 and has a vega of 18.1. Implied volatility for this option is 26.7% as I write.

If implied volatility were to increase from the current level to 27.7%, the price of this option would increase by $0.181 as a result of a one point increase in implied volatility alone. In this simple example, the “position vega” would be: 100 calls/contract *.181 vega/call or 18.1 vega/contract.

The sensitivity of an option’s price to vega is greatest in the at-the-money strike within an individual expiration cycle because this strike always contains the maximum dollar amount of time premium. In addition, longer dated options have greater vegas than shorter dated options and are therefore more sensitive to changes in current implied volatility. This effect is seen most notably in LEAP options which have the largest vega values. This exquisite sensitivity of LEAP options to volatility is critically important to recognize in designing strategies using these long term options.

The effect of vega becomes particularly important as the market prices future events expected to result in price volatility. Examples of such events include earnings releases and FDA approval of new drugs.

The failure to understand vega effects on option positions represents a major oversight in many trader’s core knowledge. Understanding and compensating for these variables will give the knowledgeable trader a significant competitive advantage.

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