I Believe in Vega
If you trade stock option time spreads, you should probably name your next daughter Vega. Vega is one of the well known Greeks spawned by the genius of the option pricing model. As you may recall, there are four principle Greeks of option legend: Delta, Gamma, Vega and Theta. Each one of these variables provides important clues about the future behavior of the stock option they constitute. Today, we talk about Vega and how it can help the stock option time spread trader.
As you may recall, Delta demonstrates the relationship between the movement of the underlying stock and its option. Usually, the higher the stock option approaches in-the-money, the higher the correlation between the movement of the stock and its derivative. For example, an out-of-the-money option may have a low correlation of .4 (the option will move about 40% of the movement of the underlying). As the option approaches in-the-money, the correlation increases. Somewhere a bit above in-the-money, the correlation will approach .9 to 1.00. At a correlation of 1.0, the movement of the option mimics the underlying; if the underlying moves up $1 so does the option premium. Of course, when an option is in-the-money it might be assigned or called away. This is not particularly desired in that the trader may have to lay out additional funds to place the stock if the underlying is not already owned. As most option time spread traders are long, the front month (naked call writing) is for premium collection. So, a time option trader needs to be aware of what will happen to an option when it moves from at-the-money (where time premium is at its maximum) into an area where an option might be assigned. This is where Vega can be very useful.
Let’s suppose you see that the front month of the option spread is moving up toward becoming in-the-money. It would be good to know when the stock price might carry the written call option into-the-money. To do this, the option trader needs to understand what Vega means and how to apply it. Vega, as you may recall, represents how much correlation- in terms of money- will the movement of the underlying affect the option. For example, a Vega of .15 would mean that a $1 increase in the underlying would move the option up 15 cents.
So, if the front month option of the time spread is at-the-money and the Vega is .30, the underlying might move up a dollar but the option would move just slightly. As a matter of fact, if delta is below 1.00 at that time, it also tells the option trader that there is not a 100% probability of the option finishing in-the- money. But needless to say, once an option nears in-the-money and a delta approaching 1.00, it might be a good time to close out at least the front month to avoid being assigned. Call it being chicken but it’s the only way I know to avoid the possibility of having to hit my account to fulfill my obligation as a naked option writer. Now, I am sure there are other ways to roll into or out of the situation but I m not familiar and would like to hear how more experienced and knowledgeable option time spread traders might do it differently.
Maybe I need to take the Advanced Options Strategy online course offered by the Options University.
Get your free 7 Deadly Sins Report and click here, presented by Options University, and register now for the Forex World Currency Options Class with Greg MaDermott, starting August 18, 2008.
If you are interested in joining Options University’s affliiate program please sign up here.
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