The Option Greeks - Vega

What Is Vega And How Does It Effect Option Prices?

When it comes to investing in or trading options, a thorough knowledge and understanding of the option greeks must be in place in order for someone to utilize options correctly.

These greeks include but are not limited to delta, gamma, theta, rho, and vega.

Options may be used for multiple purposes including hedging a position in the underlying or speculating on price direction.

One very big use of options is to trade not direction but volatility. 

This is where vega comes in....

What is Vega And How Does It Effect Option Prices?

The option greek vega represents a measurement of an option's sensitivity to changes in volatility.

Vega shows the change in an option's value for every 1% change in volatility.

For example, if a call option on XYZ stock is valued at 2.20 and has a vega of .25, all other things being equal a 1% increase in volatility would cause the value of that option to rise to 2.45.

On the other hand, should volatility levels fall off by 1% with all other things being equal then the option value would drop to 1.95.

Vega is constantly changing.

Vega typically goes up when there are large movements in the underlying asset and typically falls when the underlying asset is quiet or range bound.

Vega is highest for at-the-money options and tapers off for deep in-the-money or out-of-the-money options.

Vega is also higher for options with more time until expiration.

This is because an option that has more time until expiration is more vulnerable to swings in implied volatility.

When thinking of vega, one must simply remember volatility.

When an investor buys an option he or she is long vega, or long volatility.

When an investor sells an option, he or she is short vega, or short volatility.

It is important that an options trader or investor have a complete understanding of historical and implied volatility.

How Is Vega Used? 

We've all heard the saying "Buy low-sell high!"

When it comes to options trading, the same holds true.

Professional traders and investors will look to buy low and sell high by purchasing relatively cheap options and selling relatively expensive options.

How does one know if an option is cheap or expensive?

By monitoring historical and implied volatility levels.

Implied volatility levels are calculated using an option pricing model while historical volatility is calculated from past prices.

Basically, once all of the inputs are fed into the model such as time, underlying price, interest rates, volatility etc. the pricing model will give a theoretical value for an option.

If the option value is trading higher than the theoretical value, it is considered expensive.

If the option value is trading below theoretical value, it is considered cheap.

This allows investors to attempt to sell over priced options or buy under priced options and potentially realize a profit if the option value returns to its theoretical value.

By monitoring changes in volatility, an investor may be able to potentially position themselves to profit from an increase or decrease in volatility levels without trading market direction.

By understanding and monitoring vega, an investor can also see how a position may be effected by changes in volatility and act accordingly.