• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

Suresh Krishnamurthy

I would like to know about option variables and how these are helpful in measuring option risk? — Kiran S. Prasad

Vega: The measure of an option's sensitivity to changes in volatility of the underlying stock is referred to as Vega. Volatility of a stock refers to the fluctuations in a stock's returns. It is captured by the standard deviation of a stock's daily returns. It is also an indicator of the risk of a stock. Volatility is an input to find out the theoretical premium of an option. In practice, however, volatility is inferred from the option's premium. Vega tells us how the option premium will change if the implied volatility changes.

For instance, let us consider the case of the options of Tata Steel. On July 22, the call option of Tata Steel with a strike price of Rs 360 expiring on July 29 closed at Rs 11.55. The underlying stock price on the same date was Rs 363.50. If we feed in inputs such as an interest rate of 4.5 per cent, number of days to expiry and the dividend yield into an option calculator, then the implied volatility for the stock comes out as the output at 47.59.

If this volatility changes, then the option price will change even if the stock price does not change. Again, consider the change in option price of this call option on July 23 rd. The price fell by Rs 1.95 to close at Rs 9.60. The stock price of Tata Steel on July 23, however, went up to Rs 364.65. Why did the premium of the option of Tata Steel decline when its stock price rose? It declined because the estimated volatility has declined. Option calculator tells us that the implied volatility in the stock declined to 36.47 on July 23. Vega multiplied by the change in implied volatility substantially explains the fall of Rs 1.60 in the option premium.

Why does the implied volatility change? Risk perception relative to a stock changes in response to a multitude of factors. A couple of fundamental factors that can lead to changes in implied volatility are changes in growth estimates and change in the capital structure of the company. Market-related factors include the expected liquidity in the stock. For instance, any increase in estimates for earnings growth will lead to an increase in implied volatility and therefore a rise in option premium, which is higher relative to the change in stock price.

In the case of Tata Steel, on July 22, the company announced a massive rise in profits for the first quarter ended June 2004. On 22 July 2004, implied volatility of the Tata Steel declined modestly. This suggests that the options market expected the sharp rise in profits. The sharp fall in implied volatility on July 23, however, indicates that the options market does not feel the need to increase the estimates for profit growth for Tata Steel for the whole year.

Vega is higher for an option that is near the money. For deep-in-the-money or deep-out-of-the-money options, Vega is low. Vega is identical for both call and put options. It is always positive. Longer-term options have higher vega than shorter-term options.

(Queries relating to futures/options may be mailed to fno@thehindu.co.in or to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Investment Quiz

Copyright © 2004, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line