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Vega Versus Gamma



I was asked what criteria I use when deciding what expiration to buy when buying options.

First you must understand I do not buy a call because I think the stock is going up or a put because I think the stock is going down. I am not overly directional in nature, so I'm indifferent between calls and puts. I buy options when I think they are cheap, based on implied volatility (or sell them when I consider them expensive) and then delta hedge the options (by selling stock against a long call or buying stock against a long put on a ratio) to be neutral (at least at the start).

I went over the basic strategy for "buying volatility" called a back-spread in another article, but re-introduce the Total Return graph here:

Delta neutral: Long 1 XX 3-month 40 strike and long 37 shares of stock at $41.91

So notice that I do not care if the stock goes up or down. I am just isolating volatility because I consider the options (puts or calls) to be cheap. So my expectation is that the stock will move more than the options imply.

Another way of saying that is that I expect the option prices in general to increase, all things being equal. If the XX put above is bought at $2 and the vega is 25 cents, if the implied volatility rises by 1 point the put price will rise to $2.25. The vega of an option -- let's say one year out -- will be much greater, say $1.25. Conversely, the gamma (change in delta) is much greater for a shorter term option.

So to answer the question: If I consider the option to be cheap, I don't really want gamma, I want vega. So I will buy the longer term option if the implied volatilities are equal. If a shorter term option has a lower volatility than the longer term option, I have some more thinking to do.

The only time one should buy shorter term options high in gamma is when it is anticipated that a stock will move a lot soon. Many short-term option traders who trade direction buy and sell short-term options. But my information is almost never good enough for me to do this, and this is not my game.

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