Options & Derivatives Trading

Vega Definition

What is Vega

Vega is a measure of the sensitivity of option prices to changes in the volatility of the underlying asset. Vega represents the amount by which the option contract price changes due to a 1% change in the implied volatility of the underlying asset.

key takeaways

  • Vega measures the value of an option price relative to changes in the implied volatility of the underlying asset.
  • A long option has a positive Vega, while a short option has a negative Vega.

foundation of vega

Volatility measures the amount and speed with which prices move up and down and can be based on recent price changes, historical price changes and the expected price movement of a trading instrument. Forward options have a positive Vega, while options that expire immediately have a negative Vega. The reason for these values ​​is fairly obvious. Option holders tend to assign a higher premium to options that expire in the future than those that expire immediately.

Vega changes when the price of the underlying asset moves significantly (increasing volatility) and decreases as the option approaches expiration. Vega is one of a group of Greeks for options analysis. Some traders also use them to hedge implied volatility. An option is said to offer a competitive spread if its vega is greater than the bid-ask spread. vice versa. Vega also lets us know how much the option price will fluctuate based on changes in the volatility of the underlying asset.

Implied Volatility

Vega measures the theoretical price change per one percentage point move in implied volatility. Implied volatility is calculated using an option pricing model, which determines the current market price’s estimate of the underlying asset’s future volatility. Since implied volatility is a forecast, it may deviate from actual future volatility.

Just as price action doesn’t always go in unison, neither does vega. Vega changes over time. Therefore, traders who use it regularly monitor it. As mentioned earlier, options close to expiration tend to have lower vegas compared to similar options further away from expiration

example of vega

An option is said to offer a competitive spread if its vega is greater than the bid-ask spread. vice versa.

Vega also lets us know how much the option price will fluctuate based on changes in the volatility of the underlying asset.

Suppose Suppose that stock ABC is trading at $50 per share in January, and the February $52.50 call option has a bid price of $1.50 and an ask price of $1.55. Suppose the option has a vega of 0.25 and an implied volatility of 30%. Call options offer competitive spreads: spreads are smaller than vega. That doesn’t mean the option is a good trade, nor does it mean it will make money for option buyers. This is just a consideration, as excessive spreads can make it more difficult or more expensive to trade in and out.

If implied volatility increases to 31%, then the option bid and ask prices should increase to $1.75 and $1.80, respectively (1 x $0.25 added to the bid-ask spread). If implied volatility drops by 5%, the bid and ask prices should theoretically fall by $0.30 (5 x $0.25 = $1.25, subtracted from $1.50 and $1.55) to $0.25. An increase in volatility makes an option price higher, while a decrease in volatility makes the option price fall.

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