Trading strategy vega

The new value would be about 8. Clearly if you bought the option, you would prefer it to increase in value, and it would based solely on vega if IV increased.

What is vega in options trading?

But what if IV is high because the market has fallen and now you expect stock prices to rise and IV to drop again? This is a situation where you would not want to have a positive gamma position like a long call. If IV decreases as the market and stock moves higher, vega would decrease the premium.

So what should an option trader consider? A spread like a bull call could neutralize that positive vega risk. A bull call involves buying a call and selling a higher strike call with the same expiration. The position can benefit from a move higher in the underlying and it is considered bullish.

In the example above, the call is bought and the call is sold. But take a look at the vega on the position. Before selling the call, the position had a positive vega of 0. After selling the call, the vega position is essentially neutral.

So if IV drops, the position will not be as affected as it was before when the position had positive vega and would have lost premium. This is just one way to offset vega risk, but it can be rather effective, particularly in down markets when a move higher is expected. Let's assume that the vega of the option is 0. The more time remaining to option expiration, the higher the vega.

This makes sense as time value makes up a larger proportion of the premium for longer term options and it is the time value that is sensitive to changes in volatility. Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time Cash dividends issued by stocks have big impact on their option prices.

This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. Therefore, the vega of the overall position is By the staff at Investopedia. Get an edge on the markets with our daily trading newsletter, Trading Insights, and receive timely trade ideas covering stocks, options, futures, and more to keep you on the right side of the action.

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Staff at Investopedia. Markus Heitkoetter.