The best mantra is 'Buy cheap, sell expensive'
After a slow churn higher for stocks in 2017, volatility has re-emerged with a vengeance in 2018. What’s more, we’re currently at the heart of earnings season, with major players like Apple (AAPL) recently reporting, and several more still on deck. Against this backdrop, I sat down with Schaeffer's Senior Options Strategist Bryan Sapp to look at one of the option Greeks very relevant right now: Vega.
In simplest terms, what is vega and how does it impact option prices?
Bryan Sapp: Vega is the measurement of an option’s sensitivity to changes in the underlying asset’s volatility. Specifically, vega measures how the option’s price will change for every 1% move in implied volatility (IV). If a call option has a vega of 0.10 and is priced at $5.00, and the IV of the underlying stock rises by 1%, the call price would increase to $5.10. If the IV goes down by 1%, the call price would decrease to $4.90.
How might vega change as earnings approach?
BS: As a company’s earnings release approaches, the options market will begin pricing in a potential volatility catalyst for the underlying stock. The resulting higher IV of the options will increase, so naturally vega on the options will increase.
How does time value impact vega?
BS: Time value impacts vega in a simple way: The more time that remains until an option's expiration, the higher the vega. Options with a longer shelf life tend to be more expensive than their shorter-term counterparts, so a 1% change in IV for an underlying stock would have a greater impact on the higher-priced option.
When searching for a potential long call recommendation, say, what would be the ideal vega?
BS: There isn’t an "ideal" vega for call purchases -- just remember: the lower, the better. When buying options, you don’t want to be penalized for buying excessively expensive ones. Vega will also be very stock specific, in that what might be viewed as extremely high for one stock, could actually be viewed as low for another.
What if you’re searching for a potential short call or put recommendation?
BS: Generally, the higher the better. When selling options, you want to be compensated the most for being short volatility. That said, selling calls and puts naked (without spread protection) ahead of events like earnings can be excessively risky. Sometimes when you have big negative vega exposure, it can work against you. Everything needs to be taken into the context of the instrument you’re selling the premium on, and what potential catalysts loom before the option expires.
How would vega come into play when eyeing a potential long straddle candidate?
BS: Buying low vega when trading straddles is extremely important. Given that you’re buying double premium (calls and puts), you'll want to be especially certain that the volatility of what you’re buying is "cheap." Again, this is all relative for the particular stock or ETF, but option premium decay will be excessively fast during the times that you pay "too much" for the given straddle.
Anything else to add about vega and hunting for options winners?
BS: Generally, the best way to go is remembering to buy cheap vega options, and sell expensive.