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Welcome to Part 3 of my series on the Greeks. This article will focus on Vega and how this devil of a Greek behaves throughout the life of an option and as time to expiration approaches.
Firstly lets talk about the relationship between Implied Volatility and Time Value. Call it whichever, but both make up the ‘extrinsic’ value of an option. The extrinsic value is sometimes just referred to as the Time Value, but this ‘Time Value’ contains (if you will) the Implied Volatility as well. Now think about this: As options approach expiration, their Time Value (extrinsic value) decays, whether the option is in, out or at-the-money, until the close of expiration day when the time value (and implied volatility) reaches zero, and the option only is worth its intrinsic value if in-the-money, or otherwise zero if at or out-of-the-money. So if the Time Value is decaying, then the amount of Implied Volatility within the option is decaying as well.
As an example, if an option had $5.00 of extrinsic value at the start of its life, then any increases or decreases in volatility would have a large effect on its value, because there is a lot of ‘juice’ in the option which can be eroded (in a crush) or blown up (in a rush). But if the same option only had one week to go until expiry, was slightly out-of-the-money and only had 30 cents of extrinsic value left, then any increases in volatility wouldn’t have nearly as much an effect on its value, in a dollar measurement, and any decreases in volatility cant have much of an effect, because there physically is only 30 cents of value left – you wouldn’t be able to erode more than 30 cents out of it!
Vega is therefore larger at the start of an options life, and decreases as time to expiration approaches, especially in the last 30 days. You can see it in this example: remember Vega is the dollar amount you make or lose in a 1% point change in IV, and in the case of the option having only 30 cents of time value (or $3 total for 1 contract), Vega would be a fraction of $3 - (only the option pricing model would be able to work out exactly how much). In this same example of the option at the start of its life with $5 of extrinsic value (or $500 per contract), Vega here would be a fraction of $500 (per contract). We can see that Vega would start at a much larger number, and decrease as time to expiry approached, and as the extrinsic value of an option wasted away.
Does the Vega only decrease as time goes on? No – it can increase with stock price movement and also with an increase in IV. Vega is its highest possible value when at-the-money (ATM). If time was passing by, but the stock was gradually moving closer to the options strike price, therefore closer to ATM, then you would see Vega possibly increasing, even though time was passing by. As well if an IV rush came, Vega would increase (whether Vega be positive or negative), even though time is passing by. Vega could be theoretically pulled up and down with changes in stock price and IV.
It’s important to know how Vega is going to change as the trade moves on. Remember the Vega is the trades’ sensitivity to changes in the underlying Implied Volatility, in a dollar value. If Vega is one of the dominant Greeks you’re trading then you will need to make sure you’re firstly on the right side of Volatility (positive if you expect/want it to rise and negative if you expect/want it to fall) and then understand how Vega could help or destroy you. In the next part of this series we will go deeper into trading with this mysterious Greek.
Manage your Vega!
Matt Baker
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