Option Greeks ~ Vega and Theta

Vega and Theta

The Vega or Lambda is the change in option price due to a 1% increase or decrease in implied volatility. Vega is the most commonly used symbol however, it is not a Greek letter, so some practitioners prefer to use Lambda, and they can be interchangeable. Short term options will have a lower Vega and will not be as sensitive to changes in implied volatility. Longer term options will have higher vegas and the price will be much more sensitive to changes in implied volatility. The Theta is the rate of decay of an option’s price over time. Long option positions, whether they are calls or puts will have negative theta which means that time will work against the holder of an option through the process of price decay. Short options will have a positive theta which means that the option writer or seller can earn slow profits over time through the price decay process. Shorter term options will have a higher theta than long term options and the price can decline rapidly through decay in the final weeks or days to expiration. Longer term options will have a lower theta and a lower rate of price decay. The rate of price decay accelerates rapidly as the option approaches expiration. Covered call writers who sell call options for income usually do better by selling short term options and benefiting from the rapid price decay. In the money options will also have a lower theta and less time value than at the money options. Out of the money options that have no intrinsic value will have a relatively high theta.

One element that can make option trading tricky is understanding how many different moving parts there are and how they can affect the price of the option. For example say you a very bullish on a stock and decide to buy a call option for upside participation and to control your downside risk. The stock may move, but the stock price movement can be offset by a decline in implied volatility, so the vega can work against you. If you’re looking at a bullish strategy you need to know how the implied volatility priced into the option will impact the price. If you buy when the IV is at a very high level, even if the price of the underlying moves, if the implied volatility declines it will impact your profit. If you have a position that is long vega you want the IV to increase, if you are short vega you want the IV to decrease.

Covered call writers want to be short theta, they want the option decay to work on their side. When you sell an option, whether it is covered or not, you will be short theta and also short vega, so you want the IV to decrease, and the underlying to not move too much so you can earn the theta or the decay of the option price with time.

 

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About sellacalloption

Author, Radio Show Host and Portfolio manager and chief option strategist for IWC Asset Management.

Posted on January 14, 2012, in Option Basics and tagged , , , , . Bookmark the permalink. 1 Comment.

  1. (Hardcover) If you are ieetrestnd in trading options and have some basic options knowledge, this book is well worth the small investment to gain insight into options trading mechanics. Most options books I have bought do not cover greeks in this amount of detail. When setting up a spread, this book gives a detailed analysis on the effect of each greek in the position. It covers many of the common types of trades.

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