Tuesday, June 30, 2009

Vega Part I

So far in our Greeks overview we’ve tackled Delta, Theta, and Gamma. Since I’ve highlighted volatility with increasing frequency over recent posts, I figure it’s high time to give an in depth overview of Vega. Though Vega is not a Greek letter, it is one of the greek variables commonly used to measure option risk. Specifically, Vega measures an option’s sensitivity to a one point change in implied volatility. Let’s kick off our conversation with a primer on implied volatility.

Implied Volatility

There are two definitions I like to use when explaining implied volatility. First, it is the expectation of future volatility. The options board is perpetually trying to accurately price in the volatility the underlying stock will exhibit in the future. If the underlying stock’s realized volatility is expected to increase, you’ll see implied volatility rise. Conversely, if the stock’s realized volatility is expected to diminish, implied volatility will fall. Although the options market is usually efficient and does a pretty good job accurately predicting future volatility, there are obviously times when it gets it wrong. Trading volatility is primarily about exploiting opportunities that arise when options seem to be underpricing (in which case I’d be a buyer of volatility via strategies such as straddles or strangles), or overpricing (in which case I’d be a seller of volatility via strategies such as short strangles or condors) future realized volatility.

Implied volatility is derived from option prices. When plugged into a theoretical option pricing model, such as Black-Scholes, it makes the theoretical option price equal to the current option price. In other words, implied volatility is the level of volatility the underlying stock must exhibit or realize between now and expiration to justify current option premiums. If in that time frame the underlying stock exhibits less volatility than was originally implied, the option was theoretically overpriced. Conversely, if the stock exhibits or realizes more volatility than originally implied, the option was theoretically underpriced.

For example, the VIX (implied volatility for 30 day SPX options) currently resides around 26%. If over the next 30 days the SPX realizes 10% volatility, current SPX options are severely overpriced. Conversely, if the SPX realizes 40% volatility, current options are severely underpriced. As you can imagine if the SPX realizes 26% over the next 30 days then current options are fairly priced, meaning volatility buyers or sellers don’t really have much of an edge.

Volatility is easiest understood when thought about in extremes, so let’s explore two scenarios on either end of the volatility spectrum.

Scenario #1- Low (or no) Implied Volatility

Suppose stock XYZ closed its trading session around $40 a share. That night news hit the wires that one of XYZ’s key competitors, ABC, had submitted an offer to buy XYZ’s company at $60 a share. The next day, XYZ stock gaps up to $56 shares and it begins to drift higher toward $60. Throughout the week, the buyout gets approved by XYZ’s board and is therefore all but a done deal. The stock begins to trade in a relatively tight range around $60 as market participants realize it isn’t worth any more or less than $60. Because the stock is getting bought out at $60, the expectation of future volatility(e.g. implied volatility) is essentially 0%. A glance at the options board will probably show all OTM options, short term as well as long term, trading around $0 as no one is willing to bid up option premiums because they know the stock isn't going anywhere.

Scenario #2- High Implied Volatility

Biotech stock CRZY closed the day’s trading session around $40 a share. That night news came out that CRZY just initiated clinical trials on a drug with the potential to cure cancer. Because the potential revenues from sales of such a drug are so enormous, CRZY opens at $50 the next day. As speculation runs rampant, option traders begin to aggressively buy up OTM options looking to profit from the potential run up in price. This huge demand and subsequent increase in option premiums drives up implied volatility to 300%. Unlike scenario #1, the expectation of the stocks future volatility is huge. As such, option traders are more than willing to pay higher prices for options because they expect to be justly compensated by a large move in the underlying stock.

For more information on volatility I would highly recommend taking a stroll over to VIX AND MORE, which contains an extensive repository of info. The blog’s author, Bill Luby, possesses a knack for demystifying the more esoteric nuances of volatility.

Next time we’ll delve into the intricacies of Vega.

Follow me on Twitter.

No comments: