Uploaded by HedgeFundGroup on 26.06.2012

Transcript:

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.

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.