When implied volatility moves up and down a lot, as it has been in recent weeks, most of us become more attuned to our portfolio's exposure to vega.

As a reminder, vega is one of the Greeks and is usually defined as "the measurement of an option's sensitivity to the changes in the volatility of the underlying asset.”

Vega is typically expressed as the amount of money that an option's value will gain or lose as volatility rises or falls by 1%. All options (calls and puts) generally increase in value when volatility expands, and decline in value when volatility contracts - all else being equal.

Generally speaking, options with longer-dated maturities will have a higher percentage of vega than options with shorter-dated maturities. Also, vega is higher for at-the-money (ATM) options as compared to out-of-the-money (OTM) options.

Looking at a practical example, imagine a hypothetical put in SPY that has a vega of 0.20.

If the VIX increases by one point, the value of the above option will theoretically increase by $0.20. Likewise, if the VIX drops by 1, the value of that option should theoretically decrease by $0.20.

If you are short the above option, and the VIX goes down by 1, that’s beneficial to your position. If you are long the option, and the VIX goes down by 1, that's theoretically detrimental to your position.

Having reviewed some of the key aspects of vega, we can now take a closer look at some new tastytrade research on the subject.

On a recent episode of Market Measures, the hosts shift the vega conversation from individual positions, to spread positions. The focus of the episode is whether or not different types of spreads can help unlock superior performance in terms of vega and the bottom line.

In order to keep the focus on vega, the episode focuses on delta-neutral spreads (straddles and strangles), because this helps to remove the directional impact on P/L from the equation.

The specific question asked on the show is whether there's a optimal strategic approach for getting short the most vega, with the least amount of risk.

In order to answer this question, a study is designed in SPY that backtests three different spreads using data from 2005 to 2017. The three different spreads backtested in the study were a straddle, a 30 delta strangle, and a 16 delta strangle.

While the complete results of the study are certainly worth reviewing, the key takeaway from the study appears to be that when trading vega, the proportion of risk versus reward tends to remain relatively constant. In short, that means that if you take on more vega, no matter whether it's an individual position or a spread, the amount of risk in the position rises by an equal amount.

The findings from this examination seem to suggest that diversification is prudent, even from a vega perspective. This dovetails well with previous tastytrade research that indicates diversifying in terms of underlying and strategy (i.e. position type) can help reduce risk in the portfolio.

We hope you'll take the time to review the complete episode of Market Measures focusing on vega risk when your schedule allows.

In the meantime, if you have any comments or questions relating to the above material, we hope you'll reach out by leaving a message in the space below, or contacting us at @tastytrade on Twitter by email  at support@tastytrade.com.

Thanks for reading!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.  

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.