Day 4. Vega Value - A Weapon of Increasing Time Value

Hello！

Welcome to Tiger Academy - 「Options Greeks Column」episode 4.

In our previous article, we introduced the concept of the theta coefficient and summarized several investment principles related to the time value of options. However, in the end, we mentioned that even though theta is always negative and time value steadily decays as the expiration date approaches, many investors have noticed that the time value of options actually increases as the expiration date draws near. Why does this happen?

Today, we will address these questions by delving into another Greek value of options - the Vega value. First, let's explore what Vega value in options is.

1.What is the Vega Value of an Option?

The Vega value represents the change in the option's price for a one-unit change in volatility. Since volatility is usually expressed as a percentage, Vega measures how much the option's price changes for a 1% change in volatility.

For example, consider a call option with a strike price of $210 expiring on October 27, 2023, for Tesla. If this option has a Vega value of 0.06, it means that, all other factors being equal, when Tesla's stock price volatility increases by 1%, the price of this option will rise by $0.06.

Now that we understand the basic principles, what are the characteristics of the Vega value?

Similar to gamma and theta values, at-the-money options have the highest Vega values. This is because even a small change in the underlying stock's volatility can potentially turn an at-the-money option into an in-the-money option. Additionally, the impact of gamma acceleration can result in significant changes in option prices.

Furthermore, under equivalent conditions, as the time to expiration shortens, the Vega value becomes smaller. This is because as the expiration date approaches, the potential for profit or loss on the option becomes more certain. Even if the underlying asset experiences increased volatility, it becomes increasingly challenging to affect the option's price.

So, with these two characteristics in mind, how can we explain the initial question: why does time value continuously decay as the expiration date approaches, yet in practice, it often increases?

To answer this question, we need to explore the relationship between Vega value and time value.

2.The Relationship Between Vega and Time Value

In our previous article, "Day 3: As Expiration Approaches, Time Value Shrinks—Can You Believe It?" we discussed how time value diminishes as the expiration date nears. However, aside from the factor of time, time value is also influenced by implied volatility. When implied volatility increases, time value also increases. For example, let's consider a scenario:

Today is November 1, 2023, and an investor buys an out-of-the-money call option with a strike price of $100, expiring on December 1, 2023. The underlying asset's current price is $90, the option premium is $10, and there is no intrinsic value, so the time value is $10.

If the underlying asset doesn't experience significant volatility, it's expected that as December 1 approaches, the time value will steadily decrease to zero. However, if there is substantial volatility in the underlying asset during this period, the option's price may increase. For example, on November 20, the underlying asset's price rises from $90 to $98. At this point, even though the option still has no intrinsic value, its price increases to $12, and the time value becomes $12. Time value increases due to the change in volatility, a scenario that is quite common in practice.

But why does time value increase when volatility rises? To understand this, we need to grasp the essence of time value. Time value essentially represents the uncertainty of future option profits. The greater the uncertainty, the higher the time value. This uncertainty is influenced by two factors: time and volatility. The longer the time, the greater the uncertainty, and thus, the higher the time value. The higher the volatility, the greater the uncertainty, and again, the higher the time value.

So, even as the expiration date approaches, if volatility increases, time value can potentially increase instead of decreasing.

Vega reflects how much the option price changes for a one-percent change in volatility, which essentially means how much time value changes. It's thanks to Vega that buyers can benefit from the increase in time value caused by rising volatility while holding the option.

Now that we understand the basic principles of Vega, how can we use Vega values to make money?

3.How to Use Vega in Options Strategies

Before discussing how to make money, let's talk about how to avoid losses. When Vega is high, it's generally advisable to avoid being a buyer because, in such situations, buying options can lead to potential losses even if you correctly predict the direction of the market due to a decrease in Vega.

One of the most typical examples is speculating on earnings reports. Prior to the release of earnings reports, implied volatility tends to increase due to heightened uncertainty, causing Vega to rise. During this time, options can become quite expensive. However, after the earnings report is released, implied volatility and Vega typically decrease rapidly (as seen in the chart below), causing option prices to shrink swiftly. Therefore, even if you make the correct directional bet, the rapid reduction in option prices can result in unprofitable outcomes.

Not to mention the risk of betting on the wrong market direction, which can result in even greater losses. Therefore, it's advisable to refrain from buying options when Vega is high.

If you want to profit from volatility contraction, you can consider employing strategies like straddles and iron condors to benefit from the reduction in volatility and Vega. We have discussed these two strategies in detail in our course on combination options, specifically in Strategy 3: "4.Strategy3: Practical Application of Straddle Options Strategy" and Strategy 4: "Strategy4:Low-Cost Arbitrage in High Volatility—Practical Application of Strangle Options Strategy"

That concludes today's content. If you found this article helpful, please feel free to like and share it. By doing so, you can earn Tiger Coins!