Vega | CHP

Uploaded by HedgeFundGroup on 26.06.2012

In this short video we will discuss implied volatility risk which is also known as Vega
risk. We will first define implied volatility, and then touch on the risk associated with
implied volatility. The discussion will move on to examining how a moving market effects
a portfolio managers vega and how to hedge implied volatility risk.
Implied Volatility Implied volatility is an estimate by market
participants on how much an asset will move over a specific period on an annualized basis.
Implied volatility is inherent in all options position and is one of the most important
inputs into determining the price/value of an option.
Implied volatility is different from historical volatility as implied volatility is what is
expected to happen to the movement of a security while historical volatility is a measure of
what actually happened. Historical implied volatility is the historical observation of
implied volatilities. Implied volatility can be such a strong factor
in determining the price of an option, that large movements can offset any positive gains
relative to directional movement in a security. For example, an investor could own a call
option on Apple stock at $600, when the underlying market is $575, and implied volatility is
50%. A move to $600 on one day could be offset by a decline in implied volatility to 30%.
There is a general rule of thumb in which 70% of call option expire out of the money.
The reason for this phenomenon is that implied volatility is generally higher than historical
volatility. Implied volatility is traded actively throughout
the marketplace. Over the past 10 years, the VIX volatility index has become one of the
more popular ways for traders to speculate on the direction of implied volatile.
The VIX volatility index measures the "at the money" strikes of the S&P 500 index on a dynamic
basis. As the VIX increases, investors are speculating that implied volatility will move
higher. The VIX has been label as a fear gage. Higher VIX levels are generally associated
with fear that the equity markets will fall. Investors will use the VIX (which is available
in futures, options on futures and ETF form) as a way to hedge a portfolio of stocks.
Investors will initiate position specifically designed to take advantage of implied volatility.
Implied volatility is a mean reverting process and can be measured to determine if it is
rich or cheap. By using historical deviation from a mean, some strategists initiate long
or short positions in implied volatility which is referred to as vega.
Vega Vega is the exposure an investor has to implied
volatility. Similar to exposure to outright directional movements, Vega measures how a
portfolio of options (or a single option) will perform if implied volatility increases
or decreases. Vega is measured as a decimal and usually
converted into a dollar figure. The dollar figure represents the amount of money that
will be made or lost for a 1% move in implied volatility. For example, a vega of 10,000
will theoretically make 10,000 for a 1% increase in implied volatility.
Strike Risk As a security price moves higher and lower,
the exposure an investor has to vega will change based on the proximity to the strikes
of the option in a portfolio. The closer the underlying price is the strike of a long option
position, the higher the vega of the position. Far out of the money options usually have
very little exposure to implied volatility. Strike risk as it pertains to vega can be
tricky. An investors can own a portfolio of options that are both long and short. Despite
having an overwhelming number of purchased options, if the underlying price of the securities
is closer to short options strike prices, the vega will be negative.
Hedging Vega Risk Vega risk needs to be hedge with options.
Other Greek risks such as delta can be hedged using outright positions, but vega can only
be offset with another option. Most traders will use similar options combining different
strikes or offsetting expiration dates to mitigate vega risk.
Overall, options positions can be complex and hard to understand and investors speculating
in these securities should be aware of the different risks associated with option positions.