Vega in Option Greeks: The 4th Factors to Measure Risk

Vega

Heavy winds and thunderstorms can cause the electrical voltage in your home to experience wild fluctuations. These spikes in voltage can lead to voltage surges, which could have a severe impact on your electronic devices.

Similarly, when the market is volatile, equity and index prices can move drastically. For example, an equity that was trading at Rs 150 could swing between Rs 135 and Rs 165. The situation becomes nerve-wracking for PUT option writers when the equity falls to Rs 135 as this means their options have good chance of closing in-the-money. Similarly, CALL option writers also feel anxious when the equity moves up to Rs 165 as this raises chances of their options expiring in-the-money.

Regardless of whether Calls or Puts are involved, when volatility rises the likelihood of an option expiring in the money increases. To illustrate this, consider someone wanting to write 750 CE options with the spot price at 720 and 10 days remaining until expiration, whilst there may be no intrinsic value the option will have some time value. As an example let’s say the premium is Rs 28; they could pocket that money by writing the option, however if over that 10 day period volatility is forecasted to increase due to upcoming election results or corporate results then it is likely that the option may end in-the-money and all their collected premiums may be lost. Due to this fear of potential loss, what incentive do people have for writing options? The answer is a higher premium amount, had the premium been Rs 42 or Rs 55 instead then it would certainly make them think twice about writing it.

When volatility is anticipated to rise, option writers become anxious that they may be put in a situation where the option they’ve written will turn out to be in the money. Nonetheless, fear can be dealt with for a cost, so option writers demand greater premiums for writing options, thus making calls and puts costlier when volatility is expected to rise.

Check out the graph below that emphasises the same point:

It can be seen that, when volatility rises, both call and put premiums also go up. The graphs here further demonstrate how the option premium is affected by changes in volatility and the number of days until expiry.

Examine the first chart (CE). The blue line indicates the effect of volatility on premiums when there are 30 days left to expiry; whilst green and red represent it with 15 days and 5 days till expiry, respectively.

Taking this into consideration, here are a few points (these are pertinent to both Put and Call options):

Regarding the Blue line, with 30 days remaining until expiration, a volatility shift from 15% to 30% results in a premium increase from 145 to 285, indicating a significant 96% change in the rate

Examining the Green line, during the mid-series with 15 days until expiry, if the volatility rises from 15% to 30%, the premium rises from 100 to 150, representing an approximate 50% change in the premium

Analysing the Red line, with only 5 days left until expiry (towards the end of the series), an increase in volatility from 15% to 30% leads to a premium increase from 57 to 84, signifying a roughly 47% change in the premium

Taking the observations into account, we can draw a few conclusions:

The graphs illustrate the impact of a 100% increase in volatility, from 15% to 30%, on premiums. This study is intended to discern the behaviour of volatility and its effect on premiums over time. Note that the same pattern applies even when volatility changes by smaller margins such as 20-30%, with a corresponding proportionate shift in premium

The start of a series when volatility is high can be beneficial; it’s a great opportunity to collect premiums from writing options. These premiums will likely decrease when the volatility cools off, allowing you to benefit from the difference between the two points

When nearing expiry, volatility often causes a rise in premiums, but not as much as when there is more time left. If you’re wondering why your long options aren’t performing optimally in a volatile situation, make sure to check the time to expiry

It is evident that as volatility rises, premiums become higher, but the magnitude of this is not known. This is what Vega reveals.

The Vega of an option quantifies the extent to which its value, or premium, fluctuates in response to each percentage change in volatility. Since options grow when volatility increases, this figure is always positive for both call and put options. For example—if the option’s vega is 0.18, it will experience a 0.18 change in theoretical value for each percentage of fluctuation in volatility.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding Vega and its impact on option premiums proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending how volatility changes affect option pricing enables more informed decisions about when to buy or sell options based on volatility expectations.

Taking Things Forward

It is now the perfect time to reexamine the course of this Option Trading module and where it will be headed in the upcoming chapters.

We began by grasping the fundamentals of options and then delved further into Call and Put options from both buyers’ and sellers’ viewpoints. Following this, we explored moneyness of options and other technical intricacies associated with them.

We additionally learned about option Greeks, including Delta, Gamma, Theta, and Vega. We also reviewed a mini series of topics related to Normal Distribution and Volatility.

At this point, our insight into the Greek landscape is one-sided. We know that when market activity shifts, option premiums follow in line with their respective delta values. In actuality however, numerous elements come into play all at once. Markets could wave unpredictably and volatility take a wild turn, leading to liquidity being rapidly withdrawn from the options on the daily. This can be a lot for beginner traders to take in and can be so much that they often draw comparisons between the markets and casinos.

The main point I want to highlight is that the Greeks have a significant impact on premiums, leading to their constant and rapid fluctuations. It is therefore essential for traders to grasp these inter-Greek relationships in order to be successful. In the upcoming chapter, we shall gain insight into the Black & Scholes options pricing model and its applications.

(Read the following article from Business Line dated 31st August 2015)

On August 24, 2015, there were several noteworthy occurrences in the options markets. Here are some key data points from that day:

Nifty declined by 4.92% or about 490 points:

India VIX shot up by 64%:

But Call option Premiums shot up!

Traders with knowledge of options are aware that call option premiums decrease when the market drops. Most of these below 8,600 did indeed go down, however those above 8,650 behaved differently; rather than deflating, their premiums grew by 50-80%. This has left many astounded, and giving rise to various wild theories such as rate rigging, manipulation and technical malfunctions. But I think there is a legitimate justification behind it, we can explain this based on the principles of options theory.

We are aware that option premiums are impacted by the Option Greeks, specifically Delta. This metric measures how much the value of an option changes compared to a one-point increase or decrease in the underlying security. For example, if a particular call option has a Delta of 0.75, then it is expected to rise or fall by 0.75 points for every point the underlying increases or decreases. On August 24th, when Nifty declined by 490 points, those call options having ‘noticeable’ Delta (0.2, 0.3, 0.6 etc.) dropped in value as well. Moreover, as all ‘in the money’ options on that day had a strike below 8,600, their premiums decreased accordingly.

Options with a very low delta such as 0.1 or lower tend to be ‘out of the money’. August 24th was a case in point, with all options above 8,600 falling under this category; this meant that even though there was a huge decline in the market, these call options did not experience much loss in terms of their premiums.

The answer as to why premiums increased, rather than decreased, lies in Vega, an option Greek which measures sensitivity to changes in market volatility.

On 24th August, Indian markets experienced a major spike in volatility of 64%, resulting in unexpected changes to the options market. All options saw an increase in their Vega, triggering a proportionate rise in their respective premiums. This effect was especially dramatic for ‘out of the money’ options; not only did their low delta values hinder any drop in premium, but the high Vega pushed them even higher.

On 24th August 2015, we saw something extraordinary take place, call option premiums rose by 50-80%, even as markets plunged by 5.92%.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding the interplay between Option Greeks proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending how Delta, Vega, Gamma, and Theta interact simultaneously enables better understanding of seemingly counterintuitive premium movements during volatile market conditions.