Option Greeks: VEGA

Since my main trading strategy is to sell Out of The Money (OTM) Credit Spread, as specified in my Trading Plan, the second Greek that I want to talk about is Vega.

OTM Options contains only Extrinsic Value.  There are 4 factors that determine Extrinsic Value:

1. Time left to expiration (Theta)
2. Volatility of the underlying stock (Vega)
3. Changes in interest rate (Rho)
4. Dividends of the underlying stock

Besides Theta, Vega is the second greatest influence on Extrinsic Value.  Interest rate and dividend are relatively insignificant.

Vega is an estimate of how much the theoretical value of an option will change when Implied Volatility (IV) changes 1%.  An increase in IV will increase an option's price, a decrease of IV would decrease an option's price.

Vega is expressed as a positive number in Option Chain.  And there is only 1 Vega value for both Calls and Puts at the same Strike Price.  See image below.

Thus, a 1% increase in IV would increase both the Calls and Puts option by the Vega value.  While all Calls and Puts has positive Vega, your position can have either negative or positive Vega.

Vega and the position in the market:

• Long Calls and Long Puts always have positive Vega
• Short Calls and Short Puts always have negative Vega

When you Long an option (Calls or Puts) say at $1.00, with Vega say at 0.10, your option will be $1.10 when IV increase by 1% (assuming there is no move in the stock price and Theta is 0). 

When you Short an option (Calls or Puts) say at $1.00, with Vega say at 0.10, your option will be $1.10 when IV increase by 1% (assuming there is no move in the stock price and Theta is 0).  While the option price increase by 0.10, your Short position actually lose value by 0.10.  That is the reason why Short Calls and Short Puts always have negative Vega.

When you have a Spread, you have both a Short options and a Long options.  Take for example, the N225 May08'14 +16250 -16000 Call Bear Spread in the diagram below.

                                               Vega

N225 Jun12'14 16000 Call    12.7140

N225 Jun12'14 16250 Call    10.1607

While both of the Call options (16000 and 16250) are having positive Vega, the Call Bear Spread is having a negative Vega.  This is because in Call Bear Spread, you Short 16000 Call and Long 16250 Call.  The Short 16000 Call will have a negative Vega and the Long 16250 Call will have positive Vega.

-12.7140 + 10.1607 = -2.5533

Thus, the Call Bear Spread is in fact having a negative Vega of -2.5533, as indicated in the Quote Panel above.  The Call Bear Spread position will lose 2.5533 value if IV increase by 1% (assuming there is no move in the stock price and Theta is 0). 

Let's put both Theta and Vega together to see the impact to this Call Bear Spread.  

• Vega is -2.5533
• Theta is  0.8185 

IV increase by 1%

If IV increase by 1%, the Call Bear Spread will lose 1.7348 value after 1 day (assuming there is no move in the stock price).

• -2.5533 + 0.8185 = -1.7348

IV decrease by 1%

If IV decrease by 1%, the Call Bear Spread will gain 3.3718 value after 1 day (assuming there is no move in the stock price).

• 2.5533 + 0.8185 = 3.3718

Therefore, there is an advantage to sell Credit Spread when the IV is high.  So, when IV drop from the high, the Credit Spread will gain value from both Vega and Theta.  However, if you sell Credit Spread when the IV is low, the increase IV will make the Credit Spread lose more value from Vega than the value gained from Theta.