By Steve Papale
Coming up on a very important date. No not April 15. Here in Chicago we are big on St. Patrick’s Day. They even dump green dye in the Chicago River making even greener than normal. So next Tuesday don’t forget to put on your green for good luck. It might even help your P/L.
With markets whipping around so much in the last week or so we are seeing implied volatility(IV) swing around just a bit. As most options traders know, as markets move up, IV tends to fall and when markets fall, IV tends to go up. This makes sense as there is less demand for market protection when markets rally and more when markets fall.
The effect of movement in IV on our options position is measured by our vega. Specifically, vega measures how a 1% change in IV impacts our P/L.
For example, if the vega of an options position is +300, then a 1% increase in IV would theoretically cause out position to gain $300. Conversely, a fall of 1% would mean a $300 loss. Remember too that vega is a theoretical calculation, and the actual change in our bottom line may be different due to other greeks or market factors. Think of vega as a kind of thermometer.
When a person has a fever, we take the temperature by using a thermometer. The thermometer measures the change in temperature of a person. The thermometer itself is not affected by temperature change, it only is a measuring device. Same with vega. It measures how our patient (our options position) is doing as IV (temperature) is rising and falling. Vega is not affected by the IV changes themselves, it only measures them. In reality vega can be slightly affected by large changes in IV but only for far in or out of the money options and we really don’t worry about that too much. So when markets fly around, watch IV and keep note of vega. The health of the patient depends on it.