Time / Diagonal Spreads & Option PricingProvided By Options University Time Spread And Its Reaction To Increasing Volatility & How It Affects Option Pricing
The chart below shows a time spread, option pricing and its
reaction to increasing volatility. As you can see, each time
implied volatility increases, the value of the time spreads
increase. This increase would naturally favor the option pricing.
As you can see, if an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration. Of course, the vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or option pricing decreases in value. As volatility comes down, the out-month option with its higher vega will lose value to its option pricing more quickly than will the nearer month option with its lower vega. In the chart below, you will see how the time spreads option pricing is affected by decreasing volatility.
Glance back to Charts 4 and 5. Take note that the option pricing is constant. The changes in the price of the spreads are due to the change in volatility. We discussed how to use vega to calculate an options price when volatility changes. The same calculation method works for time spreads but the calculation is slightly more difficult. Discover these secret option trading strategies that will have your friends calling YOU 'the options expert' Click here!
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