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Options Trading Mastery: Effects of Volatility on the Time Spread
By: Ron Ianieri
When purchasing a time spread, the investor should pay attention to not only the movement of the stock price, but also the
movement of volatility. It plays a very large roll in the price of a time spread, which is an excellent way to take advantage of anticipated
volatility movements in a hedged fashion.
Option Volatility
Since the time spread is composed of two options, the investor should understand the role of volatility in options as well as in time spreads.
Let us start with option volatility.
We measure an option's volatility component by a term called Vega. Vega, one of the components of the pricing model, measures how much an
option's price will change with a one-point (or tick) change in implied volatility. Based on present data, the pricing model assigns the Vega for
each option at different strikes, different months and different prices of the stock.
Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 Vega,
then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to
decrease to 34 (down one tick).
Keep these facts in mind as we continue to discuss Vega:
1. Vega measures how much an option price will change as volatility changes.
2. Vega increases as you look at future months and decreases as you approach expiration.
3. Vega is highest in the at-the-money options.
4. Vega is a strike-based number. It applies whether the strike is a call or a put.
5. Vega increases as volatility increases and decreases as volatility decreases.
It is important to note that an option's volatility sensitivity increases with more time to expiration. Further out-month options have higher
Vegas than the Vegas of the near term options. The further out you go over time, the higher the Vegas become. Although increasing, they do not
progress in a linear manner. When you check the same strike price out over future months you will notice that Vega values increase as you move
out over future months.
The at-the-money strike in any month will have the highest Vega. As you move away from the at-the-money strike in either direction, the Vega
values decrease and continue to decrease the further away you get from the at-the-money strike. Remember, Vega (an option's volatility component
value) is highest in at-the-money, out-month options. Vega decreases the closer you get to expiration and the further away you move from the
at-the-money strike.
The chart below shows Vega values for QCOM options. Observe the important elements. The stock price is constant at 68.5. Volatility is constant
at 40. Time progresses from June to January. Finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out
over time and how the value decreases as you move away from the at-the-money strike.
Chart 3- Vega
Stock Price 68.5 Vol. 40
Strike June July October January
50 0 .008 .064 .114
55 .004 .030 .102 .153
60 .023 .063 .135 .184
65 .053 .090 .157 .205
70 .056 .094 .165 .215
75 .032 .077 .154 .213
80 .011 .052 .142 .203
Another important fact about Vega is that it is a strike-based number. This means that the Vega number does not differentiate between put and
call. Vega tells the volatility sensitivity of the strike regardless of whether you are looking at puts or calls. Therefore, the Vega number of a
call and its corresponding put are identical.
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