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(6) How to use point and figure trading techniques.
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Tuesday, June 26, 2007

Option Greeks: VEGA

Vega measures the sensitivity of an option’s price to changes in Implied Volatility (IV). Vega estimates how much an option price would change when volatility changes 1%.

A change in IV will affect both Calls and Puts options the same way:
An increase in IV will increase an option’s price, while a decrease in IV would decrease an option’s price.

The reason for this is that higher volatility implies greater expected fluctuations in the stock price, which means a greater possibility for an option to move into your favor by expiration.
Since higher volatility leads to higher option price (assuming other things constant), an increase in IV would benefit option buyers, but will be detrimental for option sellers (for both Calls & Puts). Whereas a decrease in IV would have a negative impact on option buyers, but will be beneficial for option sellers.

Example:
The current price of ABC May 50 Call is $3, with Vega 0.20 and the volatility of ABC stock is 35%. If the volatility of ABC increases to 36%, the ABC May 50 Call’s price will rise to $3.20. If the volatility of ABC drops to 34%, the ABC May 50 Call’s value will drop to $2.80.

Vega and the position in the market:
* Long calls and long puts both always have positive vega.
* Short calls and short puts both always have negative vega.
* Stock has zero vega – it’s value is not affected by volatility.

Positive vega means the option price increases when volatility increases, and decreases when volatility decreases.
Negative vega means the option price decreases when volatility increases, and increases when volatility decreases.

Vega of ATM, ITM & OTM Option
The impact of volatility changes is greater for ATM options than for the ITM & OTM options.
Vega is highest for ATM options, and is gradually lower as options are ITM and OTM.
This means that the when there is a change in volatility, the value of ATM options will change the most. This makes sense because ATM options have the highest time value component, and changes in Implied Volatility would only affect the time value portion of an option’s price.
Comparing between ITM & OTM options, the impact of volatility changes is greater for OTM options than it is for ITM options.

The Impact of Time Remaining to Expiration on Vega
Assuming all other things unchanged, Vega falls when volatility drops or the option gets closer to expiration.
Vega is higher when there is more time remaining to expiration. This makes sense because options with more time remaining to expiration have larger portion of time value, and it is the time value that is affected by changes in volatility.

Other Important Characteristics of Vega:
a) Vega can move even without any changes in the underlying stock price (e.g. stocks with low Historical Volatility), because Implied Volatility (IV) is the level of expected volatility.
When Implied Volatility (IV) is high, you might want to find out what causes the high expectations. It could be due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news which is expected to move the stock price drastically.
Adam's Daily Option Report has a great example in this article.

b) Vega can surge drastically due to sudden changes in the stock price, either up or down (such as a stock crash or a rapid big jump in the stock price).

To read about other Option Greeks, go to: Option Greeks.

Related Posts:
* Learn Trading from Trading Experts for FREE
* OPTION PRICING: How Is Option Priced?
* Understanding IMPLIED VOLATILITY (IV)
* Difference Between Option’s Volume and Open Interest
* Options Trading Basic – Part 2

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