What is Vega in options trading

Posted on: June 16th, 2022
By: Tadeo Lemus

What is vega?

Volatility generally benefits options, although some options more than others. Vega is a metric that measures an option’s volatility sensitivity – how much the option premium will change if implied volatility rises by one percentage point and other variables stay the same.

Vega isn’t a Greek letter, like delta, gamma, theta, or rho. Some people like to call it kappa instead of vega.

Why do they call it Vega?

It is uncertain who coined the term “vega” and when (it has undoubtedly been known and utilized since the late 1980s).

Why the name vega was chosen is not very clear. Two possible reasons are:

  1. V stands for volatility, similar to how theta represents time (t) and rho represents the rate (r).
  2. Some may say it simply sounds Greek

But there isn’t a letter in the Greek alphabet, otherwise, Vega would be used as a Greek.

What are the basics of Vega?

Volatility is a measure of how much and how rapidly the price changes up and down. It may be evaluated on current market activity, historical price fluctuations, and expected price swings in a trading instrument.

Options with a long-term expiration date have positive Vega, while those that will expire immediately have negative Vega. The reasons for these values are self-evident. Option investors tend to give higher premiums to options that expire in the future than they do to ones that expire right away.

When the underlying asset’s price is rising rapidly (higher volatility), Vega rises and falls as the option approaches expiration. Vega is one of a group of Greeks that are used in options analysis.

Vega is also a worthwhile consideration for individual traders. Some traders use vega as a hedge against implied volatility. The option’s vega is greater than the bid-ask spread, implying that it provides a competitive spread. The converse is also true. Vega tells us how much the option’s price could fluctuate based on changes in the underlying asset

Option Vega Example

Let’s say an option is currently trading at $2.50 (premium of the option) and the vega is 0.15. The implied volatility is 20%. The market expects the stock price to be 20% volatile from now until the expiration date.

The market’s expectations about the future volatility of stock are subject to a variety of reasons, like upcoming earnings calls, big events in the industry, and changes in the economy (good or bad), among others.

Usually, volatility will be much higher when there’s an uncertainty going on in the market and traders are not sure what the future holds. However, uncertainty is not always negative. Volatility is a two-edged sword, where the direction is not necessarily the most important factor, but the amount the price moves by.

In the example, if there’s uncertainty in the market, and traders aren’t sure about the stock the implied volatility will most likely increase from 20% to 21%. Since the vega was 0.15, and the volatility increased by one percentage, the option premium will increase from $2.50 to $2.65. Assuming everything else remains the same.

If the price of the underlying stock also changes due to any other factor, the price of the option also changes, and instead of the new option premium being $2.65, it may be something different.

What do the units in Vega represent?

The ratio of price change to volatility change (commonly known as the VAR) is commonly used for Vega. As a result, its units are dollars per percentage point. In practice, the units are rarely used, like with the other Greek constants.

The value of Vega

When the market is volatile, all options become more attractive. As a result, vega is a plus for both calls and puts.

There is no theoretical maximum limit to vega’s values.

Volatility (and vega) only influences the time component of option premium; it has no effect on intrinsic value. As a result, options with greater time value have higher vega as a rule.

All short option bets are negative for Vega. The underlying security has no vega.

Option Moneyness and Vega

At the money, the time value is the greatest. The most valuable options are those that are far from the money (in the money, out of the money). Options positioned farther away from the money on either side (in the money, out of the money) have less time value and vega.

In absolute terms, at-the-money options have the greatest vega, but out-of-the-money options have the largest vega as a proportion of their total (intrinsic plus time) value because their premium is solely based on time value.

Options with a longer duration or out of the money are excellent vehicles for speculating on volatility (high vega at a low price), with little exposure to the direction (delta and gamma).

How vega plays a role in the time to expiration of an option

The longer an option has to maturity, the more sensitive it is to volatility. Because volatility has more time to act in the option holder’s favor over a longer period of time, options with a longer expiration date are more volatile. The larger vega. As an option approaches expiration and loses time value, its vega decreases.

How vega is affected by volatility

Vega can also vary when implied volatility changes. Vega for at-the-money options, on the other hand, is rather steady across a wide range of volatility levels.

When the market is relatively volatile and implied volatility is low, options with a larger delta or vega have considerably less vega than they would when implied volatility is high (and their time value is large).

The delta of a contract in the money when volatility is high rises gradually, but it never reaches the same contract’s vega.

When volatility is high, the variances in vega between a wide range of strikes are quite minor (although at the money Strikes still have the highest vega).

When volatility drops, the differences become much larger, with particularly out-of-the-money and deep-in-the-money strikes’ vega decreasing as a result of declining volatility, while at-money vega stays roughly the same.

Key takeaways for Vega in options trading

  • Vega is a volatility metric derived by subtracting the historical price range of an option or contract from its current implied volatility.
  • Vega increases with volatility
  • The value of vega is higher the longer the expiration date.

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