As we have already explained earlier that Vega is about changes in implied volatility (IV). It is the rate of change of an option’s price on every 1% change in IV.
As a result, as implied volatility increases, the option prices increases and Vega goes up if everything remains up: interest rate and DTE.
Impact of Time Value or Theta on Vega
The vega for an option having more number of days to expiration will be more for the strike price than option of same strike price with fewer days to expiration.
So a monthly Nifty Option, say 17500 with monthly expiry will have more vega than 17500 expiries with weekly expiration.
The value of vega for longer-dated options is higher. But why this happens. Let’s take a real-world example.
Suppose Sachin Tendulkar goes for an insurance plan. If he plays only for 1 week, the insurance company will charge a certain premium.
When he seeks insurance monthly, the chance of getting injured is higher, the premium will also be higher.
The volatility (the fear of getting injured) is higher in the higher timeframe. Since the length of the insurance contract increases, the premium also increases as there are more unknowns in the longer-dated options.
More DTE also means less precision – more unknowns – and thus higher vega. As the time value consists the major part of premium percentage and this is sensitive to changes in volatility.
That means a higher vega with higher DTE. Also, the vega for ATM options is always higher than OTM options. All of this characteristic of vega is used to create different options strategies for different conditions.
Options Strategies For Vega
If you buy a naked call or put option, you believe that volatility will increase and premium prices for the option will go up which will more than compensate the theta decay. In the calendar spread, you sell a CE of lower timeframe and buy the same strike price CE of longer DTE, you are net vega long.
- Bullish Debit Spread: It is a long delta, long vega option strategy, and is a cheaper way to create a long delta spread.
Buy Nifty 17000 CE @110+Sell Nifty 17500 @80
It’s a bullish debit spread where you buy higher
- Bearish Debit spread: It’s a short delta, positive vega options strategy.
Buy Nifty 17000 PE @110+Sell Nifty 16800@80
How Vega Plays a Role in Calendar Spread Strategies
Calendar spreads are net positive vega which means when there is a sudden spike in the market, you gain from the volatility increase.
In a calendar spread, the short call will lose; whereas, the next expiry call option premium will increase to compensate for the loss.
It means, the mark-to-market or MTM will not make you impatient.
Also Read: Understanding Options Greeks
Most of the time, traders square off the position when there is a sudden spike in the 15 minutes chart in a short strangle.
While vega works in the favour of an options trader in calendar spread, you gain from the rate of difference in theta decay.
The near expiry month option premium will melt more than next expiry option you bought.
So, if you create a calendar spread when DTE is closer, the probability of ending in profit is higher.
In this trade, you can see the maximum loss is capped at 2460 Rs and the maximum gain is around 4000 Rs. Therefore, the risk-reward ratio is almost 1:1.6, which is very good considering the fact that POP (probability of profit) is above 54.59%.
When to Trade a Long Calendar Spread
To make a profit, it is very important to understand when to take a long calendar spread. Depending on the requirement, the strategy will change. Here we have presented the two possible scenarios:
- Calendar Spread Strategy #1 When you expect the IV or volatility to increase
Since the calendar spread is net vega positive, it is always advisable to build a spread when vega is low so that you can make money from the sudden spike because of volatility expansion.
- Calendar Spread Strategy # 2 When You Expect the time value will melt faster
When you expect the time value to decay faster, short the option at higher IV as you can make a good return through faster theta decay. Though theta for front-month expiry will also fall, it will not be as much comparing to the current month expiry.
When you are playing for bank nifty weekly expiry, it is recommended to create this spread on Wednesday after 3 pm as premium will melt drastically when the market will open next day or you can create it on Friday as premium will be drastically down after two days weekend leave.