Lesson:11 Greek Letter: 4 VEGA

We have discussed Delta, Gamma, Theta and volatility so far. Now, Will focus on Vega i.e. 4th Greek Letter.  will also study various volatility i.e. Historical Volatility, Forecasted Volatility, and Implied Volatility.

Historical Volatility is calculated based  on historical data that we learnt in lesson 10 how entire calculation works, moreover Historical volatility is very easy to calculate and helpful to derived past volatility of index or stocks. It will help us to identify the risk return ratio where option trader can have thin idea of historical volatility and based on it one can select Strike where huge chance of Out of Money expiration.

Forecasted Volatility is analysts forecast the volatility. Forecasting the volatility refers to the act of predicting the volatility over the desired time frame.

It helpful to identify option strategies which can turn in profit in future time frame. Example: Due to merger of 10 bank to 4 bank on 30th Aug. 2019 around 1 PM news Flash and sudden rise seen in the volatility. Highest volatility rise seen in PNB where almost 30% rise came with in 2 hours time. If trader expect to rise volatility say 45 to 60 in PNB, one can buy options which turn in profit once it reach to Forecasted level. Moreover, again News came on Friday while Monday 2nd Sep is holiday, so one has to keep in mind for 4 days Theta to laps in case no news or news might not impact much to particular bank.

Implied Volatility (IV) is like the people’s perception on social media. It does not matter what the historical data suggests or the implied volatility represents the market participant’s expectation on volatility. one side we have Historical volatility and Forecasted volatility which we have derived based on few assumption or calculation on other side Implied Volatility is actual volatility where trader has to pay actual premium in case Long or will received Premium in case Option Short. Implied volatility is reflected in the price of the premium.

For this reason among the three different types of volatility, the IV is usually more valued.

You may have heard or noticed India VIX on NSE website, India VIX is the official ‘Implied Volatility’ index that one can track. India VIX is computed based on a mathematical formula,

What is VIX India?

VIX is volatility index showing market momentum and market’s expectation of volatility over the near term. Volatility is often described as the “rate and magnitude of changes in prices" and in finance often referred to as risk. Volatility Index is a measure, of the amount by which an underlying Index is expected to fluctuate.

  

What is VIX India?

VIX is volatility index showing market momentum and market’s expectation of volatility over the near term. Volatility is often described as the “rate and magnitude of changes in prices" and in finance often referred to as risk. Volatility Index is a measure, of the amount by which an underlying Index is expected to fluctuate.

What is importance of VIX?

Generally VIX provide view for overall sentiment of market through which one can get idea of market and fear involved  in the market.

Basic of VIX.....

Higher the VIX higher will be fear or uncertainty

Lower the VIX index lower will be fear

So, one can get an idea of Money Flowness where VIX index is stable or higher or lower.

Can VIX is useful to make position in options?

It is very logical question, VIX is useful to me to create my option position. The answer is YES, by studying VIX we can ascertain the risk involved in stock market. In last 3 days as on 25 Feb the VIX was at high because of air strike done by Indian air force.

In a week period I.e. 1st March today VIX fall almost 20% from pick. So, market is showing some strength and almost every stock option fall drastically  due to fall in VIX. Take any name reliance volatility was 29 and during day it reach to 26, so VIX is common parameter to study overall market fear.

For more on VIX click here...

One can check that due to merger news in banking sector PNB options premium use to rise, PNB close at same level still CE and PE of PNB rises why? due to pending event of merger. One can see impact of Volatility and expected change came to option prices.

Realized Volatility is actual outcome after the event. Likewise the realized volatility is looking back in time and figuring out the actual volatility that occurred during the expiry series. It is very useful concept of Volatility as we have Historical, Forecasted and Implied like Example: Talking on PNB We have Historical Volatility of 50 in PNB, We are Forecasting 60 due to event, But on Friday it is trading near 65 i.e. Implied Volatility And now on Monday after Mega merger with 3 bank i.e. PNB+OBC+UNITED BANK India's 2nd largest bank all to gather suppose Volatility will open near 58 or around i.e. Realized Volatility but it include Movement due  to news.

Check Out SBIN movement in Option due to merger effect in other banks. Here is option chain posted of SBIN how Options prices goes up for just announcement of Other bank merger.

What is  Vega?

Vega is expected change in option price due to change in underlying. Suppose there are heavy winds and thunderstorms the electrical voltage  starts fluctuating violently, and with the increase in voltage fluctuations, there is a chance of a voltage surge and therefore the electronic equipment like TV, Charger or A.C.at house may get damaged.

Similarly,  in Stock market also when volatility increases, the price of stock or index use to move unexpected in either side. Example: PNB is the stock, merger news pending, PNB trading near 65 but after news expected to rise or fall 10% any side i.e. 60 or 70. On Monday say it touch to 60 all put writers start running to book   the stock/index price starts swinging heavily. Put options now stand a good chance of expiring in the money. Similarly, when the stock hits 70, all CALL option writers would start panicking as all the Call options now stand a good chance of expiring in the money.

Therefore irrespective of Calls or Puts when volatility increases, the option premiums have a higher chance to expire in the money. Assume Mr. A want to Write Nifty call option Strike 11400 the spot is trading at 11100, while 15 days remain to expire. Clearly, there is no intrinsic value but only time value. Hence option trading at 60 Rs. will you write option ? you can sell option and pocket premium of 60 Rs. But, what if the volatility is expected over a period of 15 days say election result or Monetary policy or big package expected to announced for bank or specific sector. As we know Increase in Volatility, the option can easily expire "IN THE MONEY", hence you may lose all the premium money say 60 Rs., while say premium is 80-90 will you think of writing the option?

This is how volatility increases- when option writers start fearing that they could be caught writing options that can potentially converted to "IN THE MONEY".

This is how option sellers demand more premium and expect better deal by asking more premium against fear, which leads to increase in volatility of stock or Nifty.

Few observation based on Volatility:

     There is direct relation between time and volatility. Higher the time, higher would be Vega.

        Change in option premium with say 30 days is more higher than 15 days time to expiry.

           In initial days Vega value stand higher for both call and put.

    Due to positive relationship with Vega and time, many times option buyer witness problem of premium gain even if underlying goes up. with increase in volatility leads to premium increase but question is how much? it will tells us by Vega.

The Vega of an option measures the rate of change of option’s value with every % change in volatility. Since options gain value with increase in volatility, the Vega is a positive number, for both calls and puts. Example – if the option has a Vega of 7.45, then for each % change in volatility, the option will gain or lose 7.45 in its theoretical value.

At this stage, our understanding on Greeks is one dimensional. For example we know that as and when the market moves the option premiums move owing to delta. But in reality, there are several factors that works simultaneously – on one hand we can have the markets moving heavily, at the same time volatility could be going crazy, liquidity of the options getting sucked in and out, and all of this while the clock keeps ticking. In fact this is exactly what happens on an everyday basis in markets. This can be a bit overwhelming for newbie traders

Learning from the lesson:

Historical Volatility is measured based on the closing prices of the stock/index.

Forecasted Volatility is forecasted by volatility forecasting models based on event impact and days of expiry.

Implied Volatility represents the market participants expectation of volatility

India VIX represents the implied volatility over the next 30 days period

Vega measures the rate of change of premium with respect to change in volatility

Options increase in premium when volatility increases

Higher the time higher would be Vega

Vega always high at ATM option

Vega changes when sudden movement seen in the counter

Happy Reading

Derivativelearn 

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