Guy Halpin In Trading Tutors Issue #147 3 March 2006 I introduced the Greeks to you. The article focused on Delta and Gamma. In this article I am going to explore their sisters; Theta and Vega.
Theta – can be defined as ‘the change in the value of an option, relative to the change in its time to expiration.’
In plain English, Theta tells us how much our position will change in price for each passing day. With long options, Theta is working against us, whilst with short options Theta is on our side. Let’s use an example to illustrate this:
We are long an option (call or put) priced at $1.00 and it has a Theta value of -0.05. Ceteris paribus (holding all other variables constant) tomorrow we can expect the option to be priced at $0.95 (1.00 - 0.05). Our position has lost $0.05 of its value.
If we were short the option, our position would have gained $0.05 in value. This is because we have sold an option for $1.00 and now can buy it back for $0.95.
The impact of Theta on your account value will vary depending on whether you are trading options in Australia or the USA. In Australia, one contract typically controls 1000 shares, whilst in the USA, one contract controls 100 shares. Using the above example which had a Theta value of -0.05, as one day passes:
In Australia one day would result in a change in your account of $50.
In USA one day would result in a change in your account of $5.
Vega – can be defined as ‘the change in price of the option relative to the change in its volatility.’
Put simply, Vega answers the question: How much does my position change with a one-point increase/decrease in volatility? If you are long an option and the IV (Implied Volatility) increases, then the position will gain value. If you are short, the position will lose value. The opposite applies for a decrease in IV.
Before illustrating Vega with examples I would like to give a brief explanation of IV.
IV is a measure of an underlying stock's volatility (or expected volatility) as reflected in the option's price. Hence, when a market moves a lot, implied volatility increases, while a slow moving market will have low volatility.
Let’s use an example of an option priced at $2.00 with a Vega of $0.06. If the IV increases by 1% the new option price will be $2.06 (2.00 + 0.06). If the IV was to drop by 1% the option would be priced at $1.94 (2.00 – 0.06). It depends on whether you are long or short as to how your position will be affected. If you are long, an IV increase (rush) is beneficial and a decrease (crush) has an adverse affect. The opposite applies for a short position, that is, an IV rush hurts you whilst a crush helps you.
Over my past two articles I have covered the Greeks and how you can use them to predict how changes in key variables will affect your position. Whether you trade stocks, futures, CFDs, warrants, bonds or options, one central theme is common – it is imperative to understand your risk. For option traders the Greeks are very useful in mapping out the implications of changes in the many variables that exist.
Make it happen!
Guy Halpin