Master Class Term Structure and Weighted Vega Option

Master Class Term Structure and Weighted Vega Option Pit

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What you will learn • • • We will talk about the Greek Vega and Theta What is the Term Structure Understanding Vega Weighting Using Forward Volatility in a calculation What does this have to do with VIX and Vol Products?

Easy Greeks – Vega and Theta

What is Vega • The simplest definition of Vega is: – The sensitivity of an options price to change in implied volatility • It is sometimes called an options’ ‘delta’ to implied volatility • Vega measures risk for a change in Volatility

Vega • The Vega S. A. T. question: – Delta is to Change in Price as Vega is to: • • White Castle Sliders Implied Volatility Chevy Camaro IROC-Z Newport Menthol Cigarettes – Vega is tradable • This is central to this class

Vega • A positive (+) Vega position will benefit with an increase in implied volatility • A negative (-) Vega position will be hurt by an increase in implied volatility • Long options have positive Vega (long juice) • Short options have negative Vega (short juice)

Implied Volatility and Vega • In practice Vega really measures changes in Implied Volatility – THUS for every 1% change in implied volatility, the option will change X number of cents per contract • To calculate multiply VEGA*CHANGE IN IV*100 – Thus a 2% increase in IV in an option that has. 20 of Vega would be: • 2*. 20*100, or $40. 00 – The VIX and Vol Products use Vega as a direction

What is Theta • The simplest definition of theta is: it is the rate at which an option’s time premium or ‘fluff’ is disappearing – How quickly is the ‘insurance value’ heading to 0 • The technical definition is the sensitivity of the option to the passage of time • Theta measures TIME RISK

Theta • A positive theta position will benefit with the passage of time (as time passes position MAKES $$$) • A negative theta position will be hurt by the passage of time (as time passes position will lose $$$) • Long options have negative theta • Short options have positive theta

Time and IV • Time and Volatility are factors in the Option Model They do a dance that rules the performance of spreads

Let’s Evaluate Theta and Vega

Term Structure Each month or week has a singular volatility that helps us determine what the market is thinking

Theta and Vega Same option strike different DTE and Vegas

Theta and Vega • Note how Theta and Vega can change in dominance for the risk in a position. – This is the Greeks telling you which one is more important

A Note on Vega and Forward Vol Is the Vega you see? Is the IV you see? • The IV changes do not always move linearly across the term structure – http: //www. optionpit. com/blog/understandingweighted-vega-spx-options

How does Volatility move? ATM volatility moves proportionally to 1/SQRT(t) For a calculation use: Or Vw= SQRT (Tw/T) x V We make the back term vols “look forward” to adjust for time We weight the Vegas to the term

Pricing Weighted Vega For Weighted Vega for standard options: Vw=SQRT(near DTE/Far DTE) X Vega Ex for 01/24/2017 10 SPY Feb 10 2017 226 calls have 205 Vega Now we weight to the Jan 27 term SQRT(3/17) X 205 = 86. 1 Vega – Let’s price a time spread

Comparing two IV’S • Normalize for time • Why do we do this? Because part of each term is shared time. • We want to find the value of the unshared time – =SQRT((T 2*vol 2^2 -T 1*vol 1^2)/(T 2 -T 1))

Creating Forward Vols This helps us assess the forward value of the IV and the value of a time spread. Also, this can measure what we give up or gain in a time spread Courtesy of A. Singh

What term is the VIX? • Now why do we care about Term Structure if we trade the Vol Products and VIX? • VIX prices a very narrow part of time. 30 days out There are lots of different vols short term but VIX cash does not price it -the Weekly futures do

VIX futures trade by the Week

Where the VIX looks

What did we learn? • Not all Volatility is created equal nor is the vega – Time needs to be normalized to get an accurate picture • We now have devices for helping to analyze volatility horizontally • Volatility seeks these numbers We use these techniques through out the course now!

Let’s Create a trade • -5 SPXW JAN 27 2265 at 2. 11 • 5 SPXW JAN 30 2265 FRO 3. 15

Thank you for attending! For question you can contact: mark@optionpit. com andrew@optionpit. com 1(888) Trade-01