# Options Trading Mastery: Effects of Volatility on the Time Spread

August 17, 2010 by admin

Filed under Option Trading

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.

The chart below shows the Vega values for calls and the corresponding puts. As you can see, these values match up in every instance.

Chart 6

Strike Price-Call Vega-Put Vega

June

60 . 023 . 023

65 . 053 . 053

70 . 056 . 056

July

60 . 063 . 063

65 . 090 . 090

70 . 094 . 094

October

60 . 135 . 135

65 . 157 . 157

70 . 165 . 165

January

60 . 184 . 184

65 . 205 . 205

70 . 215 . 215

Vega can also calculate how much a specific option’s price will change with a movement in implied volatility. You simply count how many volatility ticks implied volatility has moved. Multiply that number times the Vega and either add it (if volatility increased) to the option’s present value or subtract it (if volatility decreased) from the option’s present value to obtain the option’s new value under the new volatility assumption. The calculation works on individual options and can analyze the value of the time spread.

Apply Vega to Time Spreads

Now, let us apply the concepts of Vega to the Time Spread. When you apply the Vega concept to time spreads, you observe that as implied volatility increases, the value of the time spread increases. This is because the out-month option, with the higher Vega will increase more than the closer month option with the lower Vega. That widens or increases the spread.

The chart below shows a time spread and its reaction to increasing volatility. Each time that implied volatility increases, the value of the time spreads increase. This increase would naturally favor the buyer.

Chart 4

Stock Price $ Vol. June / July 65 Oct / July 65

65. 5 30 1. 09 2. 09

65. 5 40 1. 43 2. 75

65. 5 50 1. 77 3. 41

65. 5 60 2. 11 4. 05

65. 5 70 2. 49 4. 60

If an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.

Of course, the Vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher Vega will lose value more quickly than will the nearer month option with its lower Vega. In the chart below, you will see how decreasing volatility affects the time spread’s value.

Chart 5

Stock Price $ Vol. June / July 65 Oct / July 65

65. 5 70 2. 49 4. 60

65. 5 60 2. 11 4. 05

65. 5 50 1. 77 3. 41

65. 5 40 1. 43 2. 75

65. 5 30 1. 09 2. 09

Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.

We discussed how to use Vega to calculate an option’s price when volatility changes. The same calculation method works for time spreads but the calculation is slightly more difficult.

# How to Calculate the Volatility of the Spread in Options Trading

August 14, 2010 by admin

Filed under Option Trading

In order to be able to calculate the volatileness of propagaciÃ ³ n, we must equal volatilenesses of the options individuales.& #13; First of all, we are going to move of June of calls being moved the implÃcita volatileness of June by 40 to 36, one disminuciÃ ³ n of four garrapatas volatileness. Four volatileness of the garrapatas, multiplied by a fertile valley of. 05 by tick give a value us of $. 20. To continuaciÃ ³ n we reduced $. 20 of June the present value of 70 opciÃ ³ n of $ 2. 00 and obtains a 36 value of $ 1. 80 to volatileness. Now the two options are evaluated in a base volatileness igual.& #13; As far as this first adjustment in which trasladÃ ³ the 70 of June of volatileness up to 36 from 40, we have a value of $ 1. 80 to 36 volatileness. 40 August call volatileness has a value of $ 3. 00 to 36. Therefore propagaciÃ ³ n valdrÃ$ 1. 20 to 36 volatilidad.& #13; If you want to move August 70, solicits that, you tomarÃa the fertile valley August of call of 70. 08 and multiply by four the difference of implÃcita volatileness of garrapatas.& #13; This gives a value him of $. 32 that must be aÃ±adir to the present value of August of 70 calls with the purpose of to take it until an equal volatileness (40) with 70 June of call. To add $. 32 to 70 of August of call give to 3 dÃ ³ him lares. Value of 32 in the level of volatileness of the new ones of 40 that is the same level of volatileness that June 40 llamadas.& #13; Now, ours expansiÃ ³ n is a value of $ 1. 32 to 40 volatileness. August 70 calls of $ 3. 32 except 70 June to two the calls of dÃ ³ lares. 00 to fix the price of propagaciÃ ³ n to 40 volatilidad.& #13; ³ n does not make any difference of opciÃ that to move. The point is to establish the same level of volatileness for both options. Then already estÃready to compare apples with apples and the options to the options for a value of propagaciÃ exact ³ n and level of volatilidad.& #13; Since now we have an equal base of volatileness, we can calculate propagaciÃ ³ n of fertile valley taking the difference between opciÃ ³ n from two fertile valleys individual. In the previous example, propagaciÃ ³ n fertile valley is. 03 (. 08 -. 05). The fertile valley of propagaciÃ ³ n calculates finding the difference between those of the fertile valley of the two individual options, because in the time of propagaciÃ ³ n, that pasarÃlong time one opciÃ ³ n and cuts the other opciÃ ³ n.& #13; As volatileness moves a garrapata, you ganarÃthe value of fertile valley one of the options at the same time of losing the value fertile valley of the other. Therefore propagaciÃ ³ n of fertile valley must be equal to the difference between the fertile valley of two options. Therefore, ours expansiÃ ³ n is a value of $ 1. 20 to 36 with a volatileness. 03 fertile valley or $ 1. 32 to 40 with a volatileness. 03 vega.& #13; Returning to our value difusiÃ original ³ n of $ 1. 00 with a fertile valley from. 03, now we can calculate the volatileness of which propagan.& #13; We know the difference is a value of $ 1. 20 to 36 of volatileness with a fertile valley of. 03. Therefore, we can suppose that the commerce of difusiÃ ³ n from $ 1. 00 deberÃto develop a commercial activity in a volatileness smaller than 36.& #13; In order to know cuÃnto mÃs under is in the first place to take care of the difference both enters values extended and that is of $. 20 ($ 1. 20 to 36 volatileness less $ 1. 00 a? Volatileness). Soon we divided $. 20 by fertile valley propagaciÃ ³ n of. 03 and we obtain 6. 667 garrapatas volatileness. To continuaciÃ ³ n, to reduce 6. 667 garrapatas volatileness of the volatileness of 36 and we have 29. 33 of volatileness for the commerce of difusiÃ ³ n from $ 1. 00.& #13; TambiÃ©n can determine the volatileness of propagaciÃ ³ n like changes of prices of propagaciÃ ³ n. We are going to fix the price of difusiÃ ³ n from $ 1. 30. In order to calculate this, first we must have the value of propagaciÃ ³ n ($ 1. 20 to 36 volatileness) and of finding the difference in dÃ ³ lares between Ã©ste and the new price of propagaciÃ ³ n ($ 1. 30). The difference is of $. 10. This difference in dÃ ³ lares now is divided by the fertile valley of the differential. $. 10 divided by the difference. 03 fertile valley gives to a value of 3. 33 garrapatas volatileness him. Soon one adds the 3. 33 garrapatas to the volatileness of 36 and propagaciÃ is obtained 39. 33 like the volatileness of the interchanges ³ n from $ 1. 30.& #13; Double-Go to verify our work by means of cÃlculo of the volatileness of the other manera.& #13; This time we are going to do cÃlculo moving the August 70 calls to the volatileness of the base of the June equality 70 calls. SegÃºn the calculated thing previously, the August 70 calls tendrÃa value of $ 3. 32 to 40 volatilidad.& #13; The June 70 two calls are worth dÃ ³ lares. 00 to 40 volatileness. AsÃ, the difference is a value of $ 1. 32 to 40 volatilidad.& #13; Now we are going to move the new price extendiÃ ³ to $ 1. 30, $. 02 mÃlow s that the value of propagaciÃ ³ n to 40 volatileness. Like before, we took the difference in the prices from propagaciÃ ³ n. The result is $. 02 ($ 1. 32 – $ 1. 30). Then, it divides $. 02 by fertile valley ours expansiÃ ³ n of. 03 (it remembers that the fertile valley of propagaciÃ ³ n is equal to the difference between the fertile valley of the two individual options). $. 02 divided by. 03 give a value us of. 67. That. 67 the volatileness of our base of 40 is due to remain. That gives 39 us. 33 (40 -. 67) the volatileness of the interchanges propagaciÃ ³ n from $ 1. 30. This volatileness responds ours cÃlculo previous to perfecciÃ ³ n.& #13; Perhaps at first sight, it is asked for quÃ© we went to travÃ©s of all these cÃlculos. With the June 70 calls to 40 volatileness, the two price of dÃ ³ lares. 00, fertile valley. 05 and 70 of August to the 36 calls of volatileness, the three price of dÃ ³ lares. 00, fertile valley. 08 Âby quÃ© not to have an average of volatileness? This us darÃa a volatileness 38 for difusiÃ ³ n with a price of $ 1. 00 when in fact $ 1. 00 in extensiÃ ³ n represent 29. 33 volatilidad.& #13; This serÃa almost nine by garrapatas ones difference that represents a friolera error of 30%! Because, as it were said previously, Fertile valley is not linear, every month of way cannot be weighed uniforms and finishes both taking an average from months. By the love of argument to suppose it did that it. We say that you find the difference of fertile valleys of the options and came above for with one propagaciÃ ³ n of the fertile valley. 03 that is the correct one. Nevertheless, when ³ n tries to calculate the volatileness of propagaciÃ and the price that tendrÃan dificultades.& #13; Now, ³ n with the price of cotizaciÃ returns to calculate propagaciÃ ³ n of $ 1. 30, or $. 30 mÃhigh s that its value in 38 volatileness. It divides that $. 30 fertile valley differentiates superior in difusiÃ ³ n from. 03. You obtain an increase of 10 by garrapatas volatileness. AÃ±ade that increases to base 38 volatileness. That means that you feel propagaciÃ ³ n negotiates to 48 volatileness instead of 39. 33 volatileness! This type of error podrÃa to be very, very expensive. It remembers, apples with apples, oranges with oranges. It does not matter that volatileness opciÃ ³ n of propagaciÃ ³ n to move the time as both options for a volatileness of the equality base.

# Best Forex Practice Account – Do This Wrong and You Will Mess Up Your Trading

July 29, 2010 by admin

Filed under Forex Trading

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