Weiss Report Blog

When purchasing a time spread, the investor should pay attention
not only to the movement of the stock price but especially to
the movement of volatility.

Volatility plays a very large roll in the price of a time spread
and, as we have stated, the time spread is an excellent way to
take advantage of anticipated volatility movements in a hedged
fashion.

Since the time spread is composed of two options, the investor
should understand the role of volatility in options as well as
in time spreads. Let’s start with option volatility.

An option’s volatility component is measured by a term called
vega. Vega, one of the components of the pricing model, measures
how much an option’s price will change with a one point (or
tick) change in implied volatility. Based on present data, the
pricing model assigns the vega for each option at different
strikes, different months and different prices of the stock.

Vega is always given in dollars per one tick volatility change.
If an option is worth $1.00 at a 35 implied volatility and it
has a .05 vega, then the option will be worth $1.05 if implied
volatility were to increase to 36 (up one tick) and $.95 if the
implied volatility were to decrease to 34 (down one tick).
Remember, vega is given in dollars per one tick volatility
change.

As we continue to discuss vega, keep these facts in mind

1. Vega measures how much an option price will change as
volatility changes.

2. Vega increases as you look at future months and decreases as
you approach expiration.

3. Vega is highest in the at the money options.

4. Vega is a strike-based number - it applies whether the strike
is a call or a put.

5. Vega increases as volatility increases and decreases as
volatility decreases.

It is important to note that an option’s volatility sensitivity
increases with more time to expiration. That is, further
out-month options have higher vegas than the vegas of the near
term options. The further out you go over time, the higher the
vegas become.

Although increasing, they do not progress in a linear manner.
When you check the same strike price out over future months you
will notice that vega values increase as you move out over
future months.

The at-the-money strike in any month will have the highest vega.
As you move away from the at-the-money strike, in either
direction, the vega values decrease and continue to decrease the
further away you get from the at-the-money strike.

Remember, vega (an option’s volatility component value) is
highest in at-the-money, out-month options. Vega decreases the
closer you get to expiration and the further away you move from
the at-the-money strike. The chart below shows vega values for
QCOM options.

As you look at the chart observe the important elements: the
stock price is constant at 68.5; volatility is constant at 40;
time progresses from June to January; and finally, the strike
price changes from 50 through 80. Notice the increasing pattern
as you go out over time. Also notice how the value decreases as
you move away from the at-the-money strike.

Another important fact about vega is that it is a strike-based
number. That means that the vega number does not differentiate
between put and call. Vega tells the volatility sensitivity of
the strike regardless of whether you are looking at puts or
calls. So, the vega number of a call and its corresponding put
are identical.