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Welcome to Part 4 of my series on the Greeks. This article will continue to focus on Vega and how to manage this Greek throughout the life of your trade.
As I said in part 3, 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. We have learnt that Vega is higher at the start of an options life, and without other external influences, decreases as time to expiration approaches - although Vega can increase and decrease further with changes in stock movement and IV levels. See part 3 for more details.
At the end of the day, we don’t know where IV is going to go, but we can certainly make a strong assumption – in fact it’s often easier to predict where IV is going to go than where a stock is going! Here’s an example, if IV always oscillated between 20% and 40%, but mostly hovered about 25%, over a 2 year period, then we could safely assume that when IV hit 40% or thereabouts it was probably going to come down soon – or more so: it just won’t be going higher. Similarly if IV was down around the 20% region, we could safely assume it wouldn’t be going much lower and would rise a little. Another very common example we may see in an IV chart is that IV lives mostly between a 35% and 55% region for a certain stock, but a week before earnings time it rises up to the level of 80% and the day after earnings it crashes down to 50%, and then oscillates in its 35%-55% range until the next earnings period. There are hundreds of stocks that have IV patterns like that – almost as regular as a heartbeat. So there are no excuses for being on the wrong side of volatility!
So to make sure we ARE on the right side of Volatility firstly we have to take a view on it. Like in the examples above, look at a 1year (minimum) IV chart and see where IV could go, and how much by, in the timeframe you expect to be in the trade. Let’s say we were in the first example above (where IV oscillates between 20% and 40%) and IV was currently at 29%. IV could go significantly up or down. Now, marry the IV chart with the stock chart, matching up the time when IV rose to 40% with what the stock did at that point, and similarly with the times when IV went down to 20%. You’ll probably see a pattern – and that pattern being that the stock was heading down or experiencing some volatility when IV rose up to 40%, or the stock was heading up or quieting out, perhaps moving sideways, when IV went down to 20%. Now assess your view on the stock – are we bullish? If so IV would probably come down if we were correct, and likewise if we were bearish and correct, IV would probably go up.
Now we decide what our Vega should look like. If we assume IV will rise then ideally we should have a positive Vega value (e.g. $6.50), or if we think IV will fall during our trade, in a perfect world we should have a negative Vega (e.g. -$6.50). But is it as black and white as that? Is it possible to get every Greek on our side? The answer is no.
The more we have of one Greek, the less we have of another, or the more we have of another one that we want less of. Managing the Greeks is continually about compromise and balance. The foremost example that comes to mind here is if we were bullish then the simplest strategy and one that will make the most from Delta, is a Long Call, but a Long Call has a positive Vega, which means the Call will lose a little from a fall in Volatility. But how much? And is that trade-off worth it for the extra Delta we gain? To be continued in Part 5.
Manage your Vega!
Matt Baker
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