Dive into the fascinating realm of Vega, a key Greek in options trading, and how it impacts implied volatility, price, and volatility skew. This post also explores the dynamics of weekly versus monthly options, taking into account significant events like earnings announcements. If you’re new to options trading or aiming to gain a deeper understanding, this one’s for you!
Implied Volatility and Volatility Skew
Each strike price in options trading has an implied volatility derived from market supply and demand. This volatility number represents what’s required to justify an option’s price. Plotting the implied volatilities across strike prices produces a curve known as the volatility skew.
Though skews typically follow a general pattern, they can vary and are prone to major changes following significant events such as earnings announcements. After an earnings reveal, as market uncertainty recedes, implied volatility levels often plummet. Options sellers try to exploit this drop, hoping that the decrease in implied volatility benefits them more than any adverse stock movement. Conversely, options buyers anticipate a larger-than-expected move in the underlying asset to compensate for the high implied volatility of the pricey option.
The Pitfall for Option Buyers
One common question in options trading is how it’s possible for option buyers to predict the direction of the stock correctly before earnings but still lose money. The answer lies in the significant role of implied volatility in determining option prices. If implied volatility drops sharply, it can considerably impact option prices. This can catch new traders off guard, especially if they correctly picked the direction but didn’t account for the volatility drop.
Understanding Skew Patterns
Volatility skew gives an insight into where the demand for options lies. Out-of-the-money puts (the put wing) and calls (the call wing) often show increased demand relative to at-the-money options. This can be attributed to option buyers looking for downside protection and speculating on the upside. However, commodities, known to move in both directions with equal force, may present a different skew pattern, often a flatter skew.
Vega, Implied Volatility, and Time to Expiration
Returning to Vega, it represents the expected change in an option’s price with a shift in implied volatility. As options draw nearer to expiration, Vega diminishes, which means a larger change in implied volatility is needed to alter the option price. As Vega shrinks and time value decreases, implied volatility needs to increase to compensate, resulting in weekly options typically having higher implied volatility than monthly ones.
Also, out-of-the-money put options often maintain their bids, largely due to institutions seeking downside protection. If the stock doesn’t move and the option price stays the same while time passes, implied volatility must rise to justify the price. Hence, a short-term weekly option versus a long-term monthly option naturally presents a steeper implied volatility curve and higher volatility levels. Understanding this natural progression is vital for informed decision-making in options trading.