An overlooked part of options trading is that many traders do not identify all their risk factors. One of the most overlooked risk factor is VEGA. VEGA is an option’s sensitivity to changes in implied volatility. When entering an options trade, one must consider two things: one, what is my risk exposure to vega and two, does this seem like a reasonable risk to take?
Let’s take a generic example of a company that is about to report earnings and for whatever reason, you are VERY bullish on the stock’s performance for the upcoming earnings release. You know that playing short term options exposes you to a lot of time decay so you believe you will take the smarter approach and use an option with much more time to expiration, let’s say you buy a call option with six months left until expiration. What many fail to realize is that it is true that longer term options will have less exposure to time decay, but will have much MORE exposure to changes in implied volatility.
In our example this could prove to be disastrous. Typically, implied volatility will be at or near its recent high levels going into events such as earnings. It would be expected that once the earnings report is released; implied volatility will regress to some sort of mean. So, if you were to buy a “VEGA-rich” option as outlined above, you could have issues due to the implosion of implied volatility post-earnings. There is even a scenario where you could be dead-on in your bullish analysis and yet still LOSE MONEY due to VEGA exposure. Proper risk analysis must be performed before entering a trade such as this.