By Darrell Martin
The first article in this series introduced the Greeks, and explained that they do not move the price of the binary option; they are a mathematical calculation derived from the price. Understanding the concepts of the Greeks can help you understand how an option changes price. Greeks are a formula to explain how much the price will move, if something else changes like time, implied volatility, price or interest rates.
Vega is not a Greek letter, but the name of a star in a constellation. Vega is the measurement of how much the option price will change, with a one percent change in implied volatility. Implied volatility is a fancy way to say expected movement.
Vega is higher on options with prices that are further from expiration and when the underlying market is closer to the strike. Implied volatility is highest right before earnings announcements and after big falls in a stock. Likewise, it is highest on binaries before a large impact news event such as the Federal Open Market Committee (FOMC) interest rate decision announcement.
Look at how a binary’s price moves before a news announcement, compared to after the news announcement. You will see a dramatic difference. The price will move slower before a big news announcement because the price is inflated to be closer to 50. This is implied volatility, the expectation of movement, not simply time or price action. High-implied volatility pushes all prices closer to 50, to the center. Therefore, prices will stay very close to 50 and will move slower before the news announcement. The reason for this is the expectation of more movement brings the probability of expiring in the money closer to 50 percent. Implied volatility can also be based on the demand for the option, in addition to the expectation of how much price may move in that time frame.
If the FOMC is about to announce a potential change in interest rates, is it probable there is more expected movement in the market just before the announcement, than there was five minutes ago? Yes, there is. If there is a news event pending, the Greek Vega measurement will be more consistent. The price will be more constant. The price change, effectively the traders making the price change, is depending on the upcoming expected movement based on a pending news announcement.
A change in implied volatility will result in a change in the price of the option. This is measured in Vega. This can cause a volatility crush right after a news announcement when implied volatility drops right after a news announcement. A volatility crush is buying an option on high premium, and then having the premium drop quickly. If you review implied volatility before and after earnings announcements on a stock, you can see high implied volatility before the announcement and then the drop in implied volatility after the announcement.
Historical volatility will govern implied volatility, except in the case of upcoming news. If there is no implied volatility, the price may move faster for example from 50 to 90 to 20. It will move all over. If there is high implied volatility, the price will move slower from 50 to 55 to 45, etc.
Vega is more important than any of the other Greeks. Higher Vega, reflects a higher impact on the price of the option, when implied volatility changes. Before news, options with high Vega will have high premium, overruling the parameters in Theta and often, even Delta (explained in the next articles).