Time / Diagonal Spreads For Commodity Options Trading

When purchasing a time spread, the investor should pay attention not only to the movement of the commodity options trading price but especially to the movement of volatility.

Volatility plays a very large roll in the price of a time spread and, as we have stated, the time spread is an excellent way to take advantage of anticipated volatility movements in a hedged fashion.

Since the time spread is composed of two options, the investor should understand the role of volatility in commodity options trading as well as in time spreads. Let’s start with commodity options trading volatility.

A commodity options trading volatility component is measured by a term called vega. Vega, one of the components of the pricing model, measures how much a commodity options trading price will change with a one point (or tick) change in implied volatility. Based on present data, the pricing model assigns the vega for each option at different strikes, different months and different commodity options trading prices.

Vega is always given in dollars per one tick volatility change. If an option from your commodity options trading is worth $1.00 at a 35 implied volatility and it has a .05 vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick). Remember, vega is given in dollars per one tick volatility change.

As we continue to discuss vega, keep these facts in mind:

1. Vega measures how much a commodity options trading price will change as volatility changes.
2. Vega increases as you look at future months and decreases as you approach expiration.
3. Vega is highest in the at the money commodity options trading.
4. Vega is a strike-based number – it applies whether the strike is a call or a put.
5. Vega increases as volatility increases and decreases as volatility decreases.

It is important to note that a commodity options trading volatility sensitivity increases with more time to expiration. That is, further out-month commodity options trading have higher vegas than the vegas of the near term options. The further out you go over time, the higher the vegas become.

Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that vega values increase as you move out over future months.

The at-the-money strike in any month will have the highest vega. As you move away from the at-the-money strike, in either direction, the vega values decrease and continue to decrease the further away you get from the at-the-money strike.

Remember, vega (an option’s volatility component value) is highest in at-the-money, out-month commodity options trading. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike. The chart below shows vega values for QCOM commodity options trading.

As you look at the chart observe the important elements: the commodity options trading price is constant at 68.5; volatility is constant at 40; time progresses from June to January; and finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time. Also notice how the value decreases as you move away from the at-the-money strike.