The Double Whammy
With the stock around $64, there is a negative vega of about seven cents. As
the stock moves lower, away from the strike, the vega gets a bit smaller.
However, the market conditions that would lead to a decline in the price of
Johnson & Johnson would likely cause implied volatility (IV) to rise. If the
stock drops, Stacie would have two things working against her—delta and
vega—a double whammy. Stacie needs to watch her vega. Exhibit 5.6
shows the vega of Stacie’s put as it changes with time and direction.
EXHIBIT 5.6 Johnson & Johnson 65 put vega.
If after one week passes Johnson & Johnson gaps lower to, say, $63.00 a
share, the vega will be 0.043 per contract. If IV subsequently rises 5 points
as a result of the stock falling, vega will make Stacie’s puts theoretically
worth 21.5 cents more per contract. She will lose $215 on vega (that’s 0.043
vega × 5 volatility points × 10 contracts) plus the adverse delta/gamma
move.
A gap opening will cause her to miss the opportunity to stop herself out at
her target price entirely. Even if the stock drifts lower, her targeted stop-loss
price will likely come sooner than expected, as the option price will likely
increase both by delta/gamma and vega resulting from rising volatility. This
can cause her to have to cover sooner, which leaves less room for error.
With this trade, increases in IV due to market direction can make it feel as if
the delta is greater than it actually is as the market declines. Conversely, IV
softening makes it feel as if the delta is smaller than it is as the market rises.
The second reason IV has importance for this trade (as for most other
strategies) is that it can give some indication of how much the market thinks
the stock can move. If IV is higher than normal, the market perceives there