An Option Vega measures the change in the price of a stock option relative to a 1% change in volatility. It increases when there are large movements in the underlying stock and when major news events (like an FDA approval) are pending. Vega belongs to a group of option measures called “the Greeks”. The Vega is the highest for at the money options. In the money options have intrinsic value and they don’t carry as much implied volatility as at the money options. Hence, the Vega is low and the option price won’t change much with an increase in implied volatility. Out of the money options also have a relatively low Vega because they trade at small dollar amounts. A 1% change in implied volatility might only change the price of the option of few pennies. When uncertainty surrounds a stock, investors by puts to hedge their position. Speculators buy options to take advantage of a large potential move. Consequently, the price of the options increases because traders want to buy options. Market Makers inflate the premiums because the risk on short option positions is elevated and they want to build in as much of a buffer as they can. Many traders buy options well in advance of an earnings announcement. They do so in a neutral manner so that they aren’t exposed to movements in the underlying stock. As the implied volatility rises, they sell their positions for a profit ahead of the earnings release. Novice traders often buy options ahead of an earnings announcement and they wonder why they lost money even though the stock moved in their direction. The answer is called a volatility crush. Once the news is out, the implied volatility is quickly sucked out of the stock options. In order to make money, option buyers need a huge move. When the implied volatility of an option is low relative to its 52-week range, you should favor buying strategies. When the implied volatility of an option is near the high end of its 52-week range, you should favor selling strategies. If an option has spiked to historically high levels without a corresponding move in the underlying stock, avoid the trade. It means that major news is pending. Traders use Vega to measure their exposure to a change in volatility.
December 30, 2008
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