Volatility trading strategies

By roma, 21 August, 2020

Inexperienced traders tend to ignore the volatility when building an option position. To understand the relationship between volatility and most option strategies, it is important to read the vega in more detail. 

A vega is an indicator of the risk of an option price being sensitive to changes in volatility. It is somewhat like a delta, which measures the sensitivity of an option to changes in the price of the underlying asset. Both Vega and Delta options influence the risk profile of an option position. These Greeks can have a combined effect on the value of an option strategy. Thus, in order to fully understand the position of your option, you must evaluate both Delta and Vega. In this article, we will consider Vega in detail.

 

Vega and the other greeks

All Greeks, including the Delta, Theta, Rho, Gamma and Vega, describe the strategy risk in terms of volatility. An option position can be "long" in terms of volatility, or "short" in terms of volatility (also "flat"). In this case, the terms "long" and "short" position have the same meaning as in stock trading. That is, if the volatility increases and the trader has a "short" position on the volatility, the trader will suffer losses, all other things being equal. And if the volatility decreases, the trader will earn from a short vega position. Conversely, if a trader has a long position, then, if the volatility increases, profit will increase, while a decrease in implied volatility will lead to losses. (Read about Greeks Options in the article Greeks Options - A Brief Description).

 

Strategy

Vega

Volatility rises

Volatility drops

Long Call

Positive

Profit

Loss

Short Call

Negative

Loss

Profit

Long Put

Positive

Profit

Loss

Short Put

Negative

Loss

Profit

Volatility is a key component of each option strategy. Since both implied and historical (or realized) volatility can fluctuate quickly and strongly, it can have a significant impact on option trading. 

We will look at some examples to get you as close as possible to the real world of trading. First, we will look at Vega using examples of buying call and put options. Figures 1 and 2 show a summary of Vega (negative for short volatility and positive for long volatility) for all positions with direct options and for many complex strategies.

Strategy

Vega

Volatility rises

Volatility drops

Long Straddle

Positive

Profit

Loss

Short Straddle

Negative

Loss

Profit

Long Strangle

Positive

Profit

Loss

Short Strangle

Negative

Loss

Profit

Long  Butterfly

Negative

Loss

Profit

Short  Butterfly

Positive

Profit

Loss

Calendar spread

Positive

Loss

Profit

Buying a standard "vanilla" call option or put option implies a positive Vega position. It means that the trader has bought volatility. Selling a call or put option sets a negative Vega (that is, the trader has sold the volatility and has a short position on the volatility). Volatility is one of the components of the pricing model. The higher the volatility, the higher the price of the option (call and put), because the volatility increases the probability of a large jump in the price of the share (or other underlying asset) during the action, which increases the probability of success for the buyer. Therefore, the value of call and put options increases as implied volatility rises. If we consider the situation on the part of the writer of an option - the writer of an option must charge a higher fee to the buyer of the option since the risk to the writer increases with increasing volatility.

At the same time, if the volatility decreases, the call and put prices should be lower. If the trader owns a call or put option and the volatility falls, the option price will also fall. Of course, this will lead to a loss of a long call and put position. On the other hand, short call and short put positions will be in profit if the volatility decreases. The volatility will have a direct impact on the value of the option, and the extent to which the price drops or rises depends on the size of the Vega. A Vega sign (negative or positive) implies changes in price as the volatility moves. That is, if the Vega is negative and the volatility increases, the trader will fix a loss. The value of Vega is also important, as it determines the size of profit and loss. So, what determines the size of Vega?

 

What does the size of vega depend on?

1: the option's moneyness

At-the-money options have the highest vega, all other parameters being equal.

 

Vega vs moneyness and expiration
Vega

2: expiration

The later the expiration, the higher the vega option, all other things being equal.

The higher the time value of the option, the higher the Vega will be. Thus, options with longer expiration (and a 50% delta, i.e. cash options) will have a higher Vega, ultimately representing a significant risk for the trader. The figure above shows the relationship of a Vega to 1) moneyness of the Call and Put options and 2) the expiry date.

Here is an example. A trader buys ATM (and fully hedges the delta, i.e. the risk of direction) per Tesla share, which trades at low levels compared to historical values.

Then the Tesla share price bounces up. Usually, volatility levels drop sharply as share prices rise. Therefore, as the imputed volatility drops, the time value of the put option will decrease, and so will the vega.

 

Conclusions

This article considers the main parameters of volatility risk in popular option strategies. We have also established why Vega is so important in analyzing and selecting a trading strategy. Of course, there are exceptions where the relationship between volatility and option price is not so obvious (for example, in the S&P 500 index), which is related to the "volatility skew" and the volatility term structure.

However, these exceptions will be fully understood only in practice in real option trading.