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Viva Las VEGA…
By Fredrick James
I recently received an interesting email from a student I was mentoring regarding the value of a call contract he purchased for speculation…
A call option contract is one where the buyer pays a premium for the right to buy at guaranteed fixed price, preferably cheaper than what the market price is, for a certain period of time an underlying asset.
For example if you have a call contract for XYZ stock, it guarantees you can buy XYZ for 25 dollars any time over the next 60 days.
Let’s also say that XYZ is currently trading at 30 dollars a share – you exercise your right and buy it for 25, and then sell it at market for 30 – profiting 5.
The neat thing with options is you can make money trading premium and never buy the stock.
The premium you pay to own an option fluctuates in price just like the underlying security does. The premise behind a call is that if the underlying stock goes up, the premium, or what the option is worth also increases in value.
Turns out the contract my student bought did not go up in value as much as he anticipated, even though the underlying security increased in value. This is a real common misunderstanding that a lot of traders fall into Ahhh… easy it is not young Skywalker.
This is due in part because of the components that make up an option’s extrinsic value, or time value, allows it to fluctuate. Much like home or car insurance you pay a premium to be insured over a certain period of time, that premium is based on several factors. The value of what is being insured and the time it will be insured are a basic two.
With options the time portion of the premium is made up of several things and volatility or Vega is one of them. The way Vega works is that it increases or decreases the contract value depending on whether or not the volatility of that stock increases or decreases.
Typically things like bad earnings or lawsuits and just plain bad management are things that can make stocks volatility go up.
Likewise things like earnings surprises and better than expected sales will make volatility go down. If a stock’s price goes up this usually is a good sign and volatility will go down.
That was the case for my student. He bought a contract that is considered out the money, which means there was no intrinsic value because the guaranteed price to buy the stock contract was higher than what the stock was actually trading at.
Using the previous example, he paid a small premium for the right to buy the stock at 35 and the stock was only trading at 30. I don’t know too many people that would pay 35 for something and turn around and sell for 30.
When this happens options are considered ‘out of the money’ and is also why the premium is very small or cheap.
Out of the money call contracts are many traders favorite way to speculate because they are cheap and can increase in value quickly should there be a large move by the underlying stock.
However that is a misconception many share…
In a perfect world and using the previous example; if you paid $1.00 for the right to buy the stock at 35 when it was trading at 30 and then the stock moved up to $31, a lot of people think their option premium would also increase by $1.00 and now be worth $2.00. This is a common misunderstanding and one that causes a lot of problems like lost fortunes.
This problem is readily solved if you understand the role of Vega…
Vega is the sensitivity to volatility the premium has. It is how much the premium will fluctuate with every % move in volatility.
For example if a contract has a Vega of .25 then for every 1% move in volatility it will increase or decrease by .25.
Using the .25 example if the stocks volatility decreases by 3% the premium will go down .75 cents. Conversely, if volatility goes up 3% the premium will increase by .75cents.
As I mentioned before many times a stocks increase is a positive sign. Positive signs can decrease a stock’s volatility.
In our example, let’s assume the stock went up $1.00 but volatility went down 2%… the premium would only increase $.50. This is because the decrease in volatility caused a $.50 decrease in premium offsetting the $1.00 gain in premium by the increase in stock value.
Many traders have a hard time with this concept and hopefully after reading this it will have cleared things up for you.
Of course there are a host of other variables that affect the time value of premium like Delta, Gama and Rho but that would be better left for another article.
In closing: understand that it is wise to be aware of the correlation between volatility and Vega. It’s one of the most important factors that affect option pricing. Vega can be identified on most option chains and should be an important element in making trading decisions.
Volatility is usually expressed in two forms, implied and historical. True volatility is a perception of risk. It’s the great unknown. That’s why smart traders use varying percentages in their calculations to get an idea of what effect it will have on pricing. What will volatility do, which way will it go is the million dollar question.