Vega?

[mikeg]

I am trying to learn the "Greeks" and was reading a thread started by WayneL, and am having trouble understanding Vega.

In the below example it says that Vega is greatest ATM, which is true in monatary terms, but I would have thought it would be taken in percentage terms, which gives the $30 call the higher Vega. So if I had bought the $25 call I will have lost approx 20% of my initial outlay, compared to approx 45% if I had purchased the $30 call.

Example: MEOW is trading at $25 with option IV's @50%, and for some inexplicable reason, you buy the $20 call for $5.50, the $25 call for $2.15, and the $30 call for $0.65

For some equally inexplicable reason IV's fall to 40% during the day, and the price hasn't changed. This is what happens:

$20 call goes from $5.50 to $5.35, you lose 15c
$25 call goes from $2.15 to $1.75, you lose 40c
$30 call goes from $0.60 to $0.35, you lose 25c

So we can see here that vega is greatest ATM.

 

[wayneL]

I am trying to learn the "Greeks" and was reading a thread started by WayneL, and am having trouble understanding Vega.

In the below example it says that Vega is greatest ATM, which is true in monatary terms, but I would have thought it would be taken in percentage terms, which gives the $30 call the higher Vega. So if I had bought the $25 call I will have lost approx 20% of my initial outlay, compared to approx 45% if I had purchased the $30 call.

Hi mikeg,

Don't forget that the $20 call is "in the money" and has $5 of intrinsic value. As long as the underlying share price remains the same (for the sake of example), this value can never be lost.

If you look as the extrinsic value of that option, (the time value) it is $0.50 and drops to $0.35. So it has lost 30% of its extrinsic value.

The main issue is that you are looking at the value of the option as an investment in itself, rather than a "derivative" of an investment. I think this is a mistake and that the underlying face value should always be considered.

In other words, if I'm trading an option, I view is as an option on a $25 share with a strike price of $25 (for eg) which costs me $2.15, rather than a $2.15 option. Subtle, but I think extremely important difference.

Cheers

 

[mikeg]

Hi Wayne,

Thanks for the reply, but still have concerns.

Don't forget that the $25 call is "in the money" and has $5 of intrinsic value.

I presume you meant the $20 call.

The main issue is that you are looking at the value of the option as an investment in itself, rather than a "derivative" of an investment. I think this is a mistake and that the underlying face value should always be considered.

Here's where we disagree. If I buy an option as an investment, I am looking for the option price to rise in value, not looking to buy the share itself.

Vega has the greatest effect when At The Money and diminishes the further you get away from the money.

So what this means is, if you have bought an ATM option at high IV's ( which you want to avoid like the pox, unless as part of a spread), you're praying that IV's don't decrease, because it's gonna hurt. It will hurt less so if your option is away from the money. Conversely if you bought an option at low IV's, you don't care if IV goes up because it's to your benefit

I still see Vega having a greater effect on the $30 call rather than the $25 ATM call. It would certainly hurt me more financially if I had bought the $30 call.

It's clear why we want to know this, If we're buying options we want to buy at lower end of an options IV' range so that vega will work in our favour

I agree with athe above quote. If I had bought the $30 call with the IV at 40% and it rose to 50% I would be approx 45% in profit, instead of approx 20% profit for the $25 ATM call.

So to me this still shows that Vega has a greater effect OTM instead of ATM.

 

[wayneL]

Yes the $20 call, sorry. I have corrected that in my earlier post.

Here's where we disagree. If I buy an option as an investment, I am looking for the option price to rise in value, not looking to buy the share itself.

That's OK, your prerogative. As long as you understand the potential effect of the greeks/vol/risk etc., and manage position size around that, no problems.

However, if you discuss options with others, it could result in confusion.

Vega IS greatest ATM in terms of dollars and cents, even if not greatest as a percentage of the original option value. Just bear that in mind when reading option material and when listening to option professionals.

Cheers

 

[mikeg]

OK, I think I understand now. Vega is greatest ATM. I was looking at it the wrong way. Does this look right.

$20 call goes from $5.50 to $5.35, you lose 15c Vega = .015
$25 call goes from $2.15 to $1.75, you lose 40c Vega = .04
$30 call goes from $0.60 to $0.35, you lose 25c Vega = .025

 

[wayneL]

OK, I think I understand now. Vega is greatest ATM. I was looking at it the wrong way. Does this look right.

$20 call goes from $5.50 to $5.35, you lose 15c Vega = .015
$25 call goes from $2.15 to $1.75, you lose 40c Vega = .04
$30 call goes from $0.60 to $0.35, you lose 25c Vega = .025

Yep, Vega = the change in option value per 1% change in volatility, so thats exactly right.

Cheers