Finance blog

THE FRITZ REPORT

If the Gamma Doesn't Get You, the Vega Just Might

November 19, 2020

So, I have had some calls to expand on the theme of my Gamma Trap post, written a little while ago. Read it here, if you haven't already. In fact, maybe everyone should go back and read that to get started, because it will be helpful to have your Option Geek hat firmly on your head before you dive into this concept: Vega.

Before we dig deeply into the Greeks (and a wee bit of math), let me first step back and say why the Vega insight is important. Vega is ultimately the route by which professional option traders make money. It's that simple. Our good friends over at the FHLB, the FFCB, and FNMA all know this game very well, as do option professionals. By no means am I urging you to become an active option trader, but you are already playing in this wonderful game quite often, whether you like it or not. Most readers of this article are generally short options throughout their balance sheets—hopefully knowingly. Where? In prepayment risk or extension risk in callable bonds, loans, deposits, advances…and the list goes on.

So, what is this Vega of which I speak? Vega represents volatility or, more precisely, the implied volatility. This magical input is what ultimately drives the price of an option. It is important to understand that professional option traders generally "make" market prices (input the implied volatility levels) and the public generally "takes" market prices. To wit, when I monitor callable bond issuance, this is what I see:

This is the New Issue Monitor via our good friends at Bloomberg. It posts all of the new issuance across the market, all day, every day. Most people will only see selected offerings from this daily onslaught.

Taker vs. Maker

What follows will be a tricky, but very important, differentiator for you. I have to admit that it is not easy to explain, but I will do my best.

Option pricing was revolutionized when firms at the Chicago Board of Trade and other exchanges actually started applying the Black-Scholes model to trading options on a real-time basis. The most notable of these firms was CRT (Chicago Research and Trading). During a significant portion of the 1980s, CRT was executing more option trades than any other firm in the world. The founder of the firm, Joe Ritchie, famously said:

"A trader on the floor with the simplest programming calculators in 1976 instantly became a one-eyed man in the land of the blind."

The secret sauce to this all was an understanding of Vega.

The Black Scholes model is not all that difficult. To solve for the price of an option, you need to know the price of the underlying asset, the strike price, the risk-free interest rate, and the time to maturity. Oh, and you also need to know the price volatility of the asset. In other words, its Vega. Of these inputs, all are knowable—and the same for everyone—except Vega. Future volatility is unknown, and unknowable. We can know the historic volatility of an asset (or group of assets), but we have to make an assumption to input Vega into a black-Scholes model. Once all of these inputs are established, then we can solve for the price of the option.

Prior to CRT (and a couple others), option prices were kind of negotiated and effectively guessed. Truly.CRT became the first real market maker in the options pits. They could, would, and did make a market in any option, at any time, with conviction and with accuracy. They were the price maker, while (most) everyone else was a price taker.

And so, here we are again—makers vs. takers. When someone buys a 7-year non-call 1 at 0.90% (see above), the loop is completed. I can know all of the inputs into the equation. The price of the option has been set at 0.90% minus the yield of the underlying. In this case, a bullet with the same maturity date would have yielded approximately 0.75%. So, the option has been taken by the market at 0.15%. A professional trader would be quickly putting this information into the Black-Scholes model and solving to "back out" what implied volatility corresponds to this pricing. We can actually get a glimpse of approximately where these realized volatilities have been via the MOVE index. In the graphic, I've inserted a horizontal line to show the average for the last two years at a level of 62.1206.

Ok, so I've had you swimming in the deep end of the pool for a while, what's my point?

Back to my title: If the Gamma doesn't get you, the Vega just might. I think most people are familiar with the simple rule of thumb: yields up means prices down, and yields down means prices up. Most of the time, we think of this in terms of the actual treasury yield curve moving, but the hidden player can actually be the Vega.

Let us consider the aforementioned 7-year non-call 1 at 0.90%. If implied volatilities surge (or just go up), then the option price will increase. That is a fact. And so, without the underlying bullet's yield moving at all, the price of the callable bond will go down. The makers will use the Black-Scholes model once again, input a new, higher value for implied volatility, and they will set a lower price for the callable bond.

This is particularly troublesome if you a consistently short options (like most readers here), because suddenly everything is upside down. All of your asset prices will drop as the makers start resetting prices. This of course will eventually lead to the Gamma trap from the earlier post.

Those darn Greeks! Some of you may be thinking—who cares? You're not a professional options trader, so why should you spend time thinking about implied volatilities? You most likely have never thoroughly considered the Black-Scholes model as a daily tool in the market place that can affect your balance sheet valuations from loans to wholesale fundings. Most of you should not be spending too much energy thinking about that! But you are competing in a high stakes game. Even if you don't consider yourself a professional options trader, you are a professional, and you do trade options implicitly all the time. Unfortunately, you are usually in the position of taker, not maker, the exception being in your ability to "make" the prices for the options you allow in your retail products, like loan prepayability and early CD surrender penalties.

But in general, you are a taker, which is actually okay, as long as you understand the forces at play.

Among other reasons, you have edges that the pure option trader often does not. For example, you can decide to avoid playing in options at all in some places, such as in your bond portfolio or in your advance stack when the makers aren't paying you enough to take them (i.e., they are setting Vega so low as to make these options unrewarding). Understanding the maker's game and the impact of broader options pricing can really give you an advantage in your game, the one we call investing/banking.

Final, final thought: Christmas is only 37 days away and I hear some of the shipping companies will not be able to handle all of the AMZN orders. Get ahead of the curve, or you may experience some serious Christmas Morning Vega!

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