As an option trader, implied volatility (IV) can be a big influence on your option trades. IV is used to determine the current price of option contracts together with other factors like time to expiration and the strike price. Keeping it simple, when IV rises, so do option prices, and when IV falls, so do option prices.

IV generally increases when the market is bearish and decreases when the market is bullish. Long options, both call and puts, have positive vega. Vega changes the option premium for every 1% IV changes. If IV rises, so do call and put premiums and vice versa. So, when an option is bought, an option trader prefers IV to increase. The option premium increases, which could lead to a profit to sell the option for more than what was paid. Of course, an option trader does not want IV to decrease after the option was purchased. Let’s take a quick look at a situation where that might happen below.

Suppose the market turned bearish and a stock you like to trade moved lower over several sessions. Most likely the IV would increase as the market and the stock you are watching moved lower. Now after several down days, the stock has dropped to support and looks as if it wants to move higher again. So you purchase a long call like the example below. The 230 strike call costs 4.85 ($485) and has a positive vega of around 0.32. 

After moving lower, IV has most likely increased. Now if the stock and market move higher again, IV is likely to come down some. With the current IV at 23.50%, if IV dropped 2% down to 21.50%, the premium would drop about 0.64 (0.32 X 2) because of vega. That is a $64 loss due to vega alone. Certainly some of if not all of the loss could be nullified by the stock increasing its premium due to a move higher from delta. But a small move higher might be negated completely.

If that is the case, a spread trade that lowers the vega risk might make more sense in the environment described above. Selling an option with negative vega would do that. Knowing how the greeks can affect your option position can be critical to making money in the options market, so know what you exposure is.

John Kmiecik, Market Taker Mentoring