When you’re entering the world of options trading, there are a few factors to take into account that affect option prices. If you want to learn the basics of options and how I’m able to multiply my money in as little as 7 days, check it out here. Now, if you don’t already know the other greeks (Delta, Gamma and Theta), you’ll want to brush up on those before you learn about vega. That said, let’s take a look at vega and how you could potentially use this to your advantage when you’re trading options.
Now, vega is considered a Greek, but it’s not actually a Greek letter. Vega measures the sensitivity of an option’s price in relation to changes in the implied volatility. If this all still sounds new to you, watch this webinar to get a basic understanding of how options work.
Getting back, more specifically, in options trading, vega indicates the change in an option’s price for each 1 percentage point move in the implied volatility.
Now, when the level implied volatility is high, in relation to historical levels, the options are thought to be expensive, or rich. When you’re long an option, if the level of implied volatility increases, the price of the option catches a bid. On the other hand, if volatility drops, the option’s price would follow suit.
Here’s a look at the Greeks in an options chain via thinkorswim.
Notice how the vega for both calls and puts are positive. However, if you write, or open to sell options – something beginners should not do whatsoever – you’re exposed to volatility moves. In other words, volatility can explode, causing the options price to move higher, hurting you short position.
Since volatility is theoretically unbounded to the upside, it does not make sense to naked short options because the losses could be insurmountable.
Now, here’s how vega works. Assume you are long calls in AAPL with a vega of 0.11, if the implied volatility increases by 1%, then the option price should increase by 11 cents, all else being equal. On the other hand, if volatility decreases by 1%, the option price would fall by 11 cents.
How Time Affects Vega
Remember, options are wasting assets. Basically, the further the expiration date, the higher the vega. Since time value makes up a bulk of option premium for longer-term options, it’s sensitive to changes in implied volatility.
Longer-term options are generally more expensive, and a 1% change in implied volatility could affect the premium significantly.
For example, assume AAPL is trading at $170 and the $170 strike price calls expiring in one month is trading at $2. On the other hand, the $170 strike price calls expiring in one year is trading at $7. If the implied volatility changes by 1%, it’s quite clear that the more expensive call would be more affected.
The Bottom Line
If you’re looking to start trading options, it’s important for you to understand the Greeks. Understanding delta, gamma, theta, and vega should help you better take into account different factors affecting your options position.
Now, if you want to see how to generate high returns, check out this webinar. You’ll get an inside look of how you could use options and generate high returns using a simple, yet complex trading system.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.