Vega: Analyzing Risk vs. Reward
Vega: Analyzing Risk vs. Reward
When implied volatility moves up and down a lot, as it has been in recent weeks, most of us become more attuned to our portfolio's exposure to vega.
As a reminder, vega is one of the Greeks and is usually defined as "the measurement of an option's sensitivity to the changes in the volatility of the underlying asset.”
Vega is typically expressed as the amount of money that an option's value will gain or lose as volatility rises or falls by 1%. All options (calls and puts) generally increase in value when volatility expands, and decline in value when volatility contracts - all else being equal.
Generally speaking, options with longer-dated maturities will have a higher percentage of vega than options with shorter-dated maturities. Also, vega is higher for at-the-money (ATM) options as compared to out-of-the-money (OTM) options.
Looking at a practical example, imagine a hypothetical put in SPY that has a vega of 0.20.
If the VIX increases by one point, the value of the above option will theoretically increase by $0.20. Likewise, if the VIX drops by 1, the value of that option should theoretically decrease by $0.20.
If you are short the above option, and the VIX goes down by 1, that’s beneficial to your position. If you are long the option, and the VIX goes down by 1, that's theoretically detrimental to your position.
Having reviewed some of the key aspects of vega, we can now take a closer look at some new tastylive research on the subject.
On a recent episode of Market Measures, the hosts shift the vega conversation from individual positions, to spread positions. The focus of the episode is whether or not different types of spreads can help unlock superior performance in terms of vega and the bottom line.
In order to keep the focus on vega, the episode focuses on delta-neutral spreads (straddles and strangles), because this helps to remove the directional impact on P/L from the equation.
The specific question asked on the show is whether there's a optimal strategic approach for getting short the most vega, with the least amount of risk.
In order to answer this question, a study is designed in SPY that backtests three different spreads using data from 2005 to 2017. The three different spreads backtested in the study were a straddle, a 30 delta strangle, and a 16 delta strangle.
While the complete results of the study are certainly worth reviewing, the key takeaway from the study appears to be that when trading vega, the proportion of risk versus reward tends to remain relatively constant. In short, that means that if you take on more vega, no matter whether it's an individual position or a spread, the amount of risk in the position rises by an equal amount.
The findings from this examination seem to suggest that diversification is prudent, even from a vega perspective. This dovetails well with previous tastylive research that indicates diversifying in terms of underlying and strategy (i.e. position type) can help reduce risk in the portfolio.
We hope you'll take the time to review the complete episode of Market Measures focusing on vega risk when your schedule allows.
In the meantime, if you have any comments or questions relating to the above material, we hope you'll reach out by leaving a message in the space below, or contacting us at @tastylive on Twitter by email at support@tastylive.com.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, digital asset, other product, transaction, or investment strategy is suitable for any person. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastylive is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer. Options, futures, and futures options are not suitable for all investors. Prior to trading securities, options, futures, or futures options, please read the applicable risk disclosures, including, but not limited to, the Characteristics and Risks of Standardized Options Disclosure and the Futures and Exchange-Traded Options Risk Disclosure found on tastytrade.com/disclosures.
tastytrade, Inc. ("tastytrade”) is a registered broker-dealer and member of FINRA, NFA, and SIPC. tastytrade was previously known as tastyworks, Inc. (“tastyworks”). tastytrade offers self-directed brokerage accounts to its customers. tastytrade does not give financial or trading advice, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastytrade’s systems, services or products. tastytrade is a wholly-owned subsidiary of tastylive, Inc.
tastytrade has entered into a Marketing Agreement with tastylive (“Marketing Agent”) whereby tastytrade pays compensation to Marketing Agent to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. tastytrade and Marketing Agent are separate entities with their own products and services. tastylive is the parent company of tastytrade.
tastycrypto is provided solely by tasty Software Solutions, LLC. tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.
© copyright 2013 - 2024 tastylive, Inc. All Rights Reserved. Applicable portions of the Terms of Use on tastylive.com apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastylive’s podcasts as necessary to view for personal use. tastylive was previously known as tastytrade, Inc. tastylive is a trademark/servicemark owned by tastylive, Inc.