Options Greeks: Vega

To be a great Options trader you must understand Volatility. In the world of Options, we measure Volatility using a Greek called Vega. Vega expresses how much your Option value will change with regards to a 1% change in Volatility.

But before we dive into that, let's first cement a basic understanding of Volatility. Volatility is expressed as an annualized number proportional to the square root of time. What does that mean? Simply put, it's the one standard deviation move Bitcoin is expected to make within a year. For example, if IV is 50% and $BTC was trading at $20k we would expect Bitcoin to be trading anywhere between $10k and $30k within a year's timeframe.

In this scenario, +/-10k is your 1 stdev move. Remember, 1 standard deviation is expected to happen 68% of the time. This specific knowledge is helpful if you are a hodler but if you are a short-timeframe trader it's really not that useful, what would be helpful however is knowing the 1 stdev. move over the course of one day.

How do you calculate this? We know Vol is proportional to time and Bitcoin trades 365 days a year, so we can calculate the implied daily move as such.

Sqrt 365=19.1

Vol = 81.98 (LXVX)

Daily Volatility = Annual Volatility/19.1

81.98/19= 4.31

From this information, we can postulate Bitcoin could potentially move around +/- 4% daily.

Note: The easiest way to find your annual ATM IV is by using tools already available, like Laevitas, or Genesis Volatility.

Vega

As mentioned, Vega is the theoretical price change for every 1% move in IV. In the example below I bought one 30d call with Volatility at 72.71 and a Vega of 17.3. If IV was to increase 1 point to 73.71, our Options price would also increase by its Vega ($17), and if IV was to decrease, our Option price would theoretically decrease by $17, all else being equal. Volatility is a key driver of Options prices so it's important to understand. One way we try and interpret Volatility data is using a metric called Skew.

Skew

The last thing we want to briefly touch on with regards to Volatility is Skew, we will need a slight knowledge of this mechanism for future articles so make sure to DYOR so you understand it thoroughly. Skew is essentially the difference between the ATM, ITM and OTM Options. Among other things, Skew is a good way to gauge sentiment because you can see if Puts are going bid over Calls, or vice versa. 

The graph below uses the formula 25d Put Volatility minus 25d Call Volatility divided by the ATM Volatility (25d Put IV - 25d Call IV / ATM IV). A higher Skew equates to a greater spread between Put IV and Call IV, which could mean traders are bidding up Put IV because they are bearish.

Another way to look at skew is using what's called the “smile”. To the right of the ATM Options the graph is measuring Call IV for each strike, to the left of the ATM Options the graph is measuring Put IV. In the illustration below I placed the cursor on the ATM Options (20k), everything to the right is Call IV and everything to the left is Put IV. Its obvious Put IV is much higher, this is probably due to our recent crash as well as the current macro environment. This tells you that traders are either still bearish or simply looking to buy insurance on their current portfolios.

Conclusion

So how is all this useful? Well, if you happen to notice “Skew” getting too far outside of its usual boundaries, you might put on what's known as a Risk Reversal, this is where you buy cheap IV and sell the expensive IV in hopes that Volatility will revert. That's an entire article in and of itself and something we go over in depth later.

The key takeaway here is that Volatility is the metric that informs you as to whether specific Options are cheap or expensive. It also gives you a broad sense of the moves your underlying is expected to make statistically. In our next article we will use this knowledge to build “Volatility Bands” which are a useful way to visualize market moves.