30 lines
2.0 KiB
Plaintext
30 lines
2.0 KiB
Plaintext
Implied Volatility (IV) and Vega
|
||
The volatility component of option values is called implied volatility (IV).
|
||
(For more on implied volatility and how it relates to vega, see Chapter 3.)
|
||
IV is a percentage, although in practice the percent sign is often omitted.
|
||
This is the value entered into a pricing model, in conjunction with the other
|
||
variables, that returns the option’s theoretical value. The higher the
|
||
volatility input, the higher the theoretical value, holding all other variables
|
||
constant. The IV level can change and often does—sometimes dramatically.
|
||
When IV rises or falls, option prices rise and fall in line with it. But by how
|
||
much?
|
||
The relationship between changes in IV and changes in an option’s value
|
||
is measured by the option’s vega. Vega is the rate of change of an option’s
|
||
theoretical value relative to a change in implied volatility . Specifically, if
|
||
the IV rises or declines by one percentage point, the theoretical value of the
|
||
option rises or declines by the amount of the option’s vega, respectively.
|
||
For example, if a call with a theoretical value of 1.82 has a vega of 0.06 and
|
||
IV rises one percentage point from, say, 17 percent to 18 percent, the new
|
||
theoretical value of the call will be 1.88—it would rise by 0.06, the amount
|
||
of the vega. If, conversely, the IV declines 1 percentage point, from 17
|
||
percent to 16 percent, the call value will drop to 1.76—that is, it would
|
||
decline by the vega.
|
||
A put with the same expiration month and the same strike on the same
|
||
underlying will have the same vega value as its corresponding call. In this
|
||
example, raising or lowering IV by one percentage point would cause the
|
||
corresponding put value to rise or decline by $0.06, just like the call.
|
||
An increase in IV and the consequent increase in option value helps the
|
||
P&(L) of long option positions and hurts short option positions. Buying a
|
||
call or a put establishes a long vega position. For short options, the opposite
|
||
is true. Rising IV adversely affects P&(L), whereas falling IV helps.
|
||
Shorting a call or put establishes a short vega position. |