Finance

Vega in Options Trading

Vega in Options Trading

Vega is the Greek that measures the sensitivity of an option to implied volatility; denoted by the Greek letters. It is the change in the options price for a one-point change in implied volatility. Traders usually refer to the volatility without the decimal point. Options Vega denotes the option’s price sensitivity to changes in the volatility of the underlying asset. It measures how much the option’s price changes in response to a 1% change in the implied volatility of the underlying asset. This article aims to provide an overview of Vega in Options Trading.

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Characteristics  and Features of Vega:

  • Vega relates only to the extrinsic value of an option, and not the intrinsic value. Whether you are buying calls or puts the Vega value is always positive. The Vega value is efficiently negative when you write the option.
  • The Vega tells you how much the price of an option should increase for every percentage point increase in the implied volatility of the underlying security. Implied volatility is calculated with an option pricing model that shows the current market estimates of the future volatility of the asset.  It is based on recent price changes, historical changes in price, and expected future price changes.  As with all Greeks, the effect of Vega is based on all other factors that affect the price of the option being equal.
  • The Vega value will be higher when there is a long time until expiration and lower when there is less time until expiration. As the expiration date of the options approach, its extrinsic value will reduce, it once again makes sense that the Vega value will reduce accordingly. Future dated options have positive vega whereas expiring options have negative vega. This is because option writers allot greater premiums for options that are expiring in the future than those that expire immediately. When the Gama value of the option is high, you can expect the Vega value to also be high.

Example:

Suppose stock XYZ is trading at $10 per share and the vega is $0.25. If the implied volatility increases by 1% The option is expected to be worth $10.25 whereas if the implied volatility were to fall by 3% it is expected to be worth $9.25.

How Traders Use Option Vega

Here is How traders use Vega in Options Trading.

Usually, traders tend to pay more attention to Gama, delta, and theta values of options than they do the Vega value. However, out of all the Greeks, however theoretically in the level of effect Vega has on prices is second to the delta. As it is slightly more complex to understand and it requires a fundamental understanding of volatility and implied volatility it is probably so widely ignored. The price moment of the underlying securities affects the price of the option than anything else is the thing that a large number of traders are far more concerned about.

An option’s Vega measures the impact of changes in the volatility of the underlying asset on the option price. It does not have any effect on the intrinsic value of options. It only affects the extrinsic or time value of the options price. As the implied volatility increases, the value of the options also rises. This helps traders determine expensive options.

From a change in volatility, there are certain trading strategies for a volatility market, even when the price of the underlying asset remains static. If you wish to use such strategies as the long straddle or the short straddle, then a good knowledge of Vega and what it means is essential. Vega can be very useful in forecasting how the price of an option is likely to move, it is worth putting in some time to understanding just what volatility and implied volatility is all about.

Bottom line:

Vega is one of the four Greek letters used to measure risk. Vega tells you how much you are exposed to changes in implied volatility. It is very difficult to predict how much implied volatility will change in a specific expiration cycle. Typically, in a longer-term expiration cycle, the implied volatility is relatively stable compared to much shorter-term expiration cycles.

 

Authors – Hariharan Krishnan and Abha Shetty

About the Authors:

Hariharan Krishnan is currently in his second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.

Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.

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