Understanding Vega in Options Trading: A Pathway to Smart Investments
Vega is the measurement of an option’s price sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an option contract’s price changes in reaction to a 1% change in the implied volatility of the underlying asset.
Key Takeaways
- Vega measures an option price’s value relative to changes in the implied volatility of an underlying asset.
- Options that are long have positive Vega, while options that are short have negative Vega.
The Basics of Vega
Volatility measures the amount and speed at which prices move up and down and can be based on recent changes in price, historical price changes, and expected moves in a trading instrument. Future-dated options have positive Vega, while options that are expiring immediately have negative Vega. This is due to the fact that option holders tend to assign greater premiums for options expiring in the future than to those that expire immediately.
Vega changes when there are large price movements (increased volatility) in the underlying asset and decreases as the option approaches expiration.
Vega is part of a group of Greek metrics used in options analysis. They are employed by traders to hedge against implied volatility. If the vega of an option is greater than the bid-ask spread, then the option is said to offer a competitive spread. Conversely, this also applies when the vega is smaller than the spread. Vega also provides insights into how much the price of the option could swing based on changes in the underlying asset’s volatility.
Implied Volatility
Vega measures the theoretical price change for each percentage point move in implied volatility. Implied volatility is calculated using an option pricing model that projects future volatility based on current market prices. Since implied volatility is a projection, it may differ from actual future volatility.
Traders can develop a vega-neutral strategy with hedges to manage risk if they believe volatility could threaten their profits.
Just as price moves are not always uniform, neither is vega. Vega changes over time, and traders who use it need to monitor it regularly. Options approaching expiration tend to have lower veas compared to similar options with more extended expiration periods.
A Practical Example of Vega
Assume hypothetical stock ABC is trading at $50 per share in January, and a February $52.50 call option has a bid price of $1.50 and an asking price of $1.55. With a vega of 0.25 and implied volatility at 30%, the call options are offering a competitive spread, as the spread is smaller than the vega.
If the implied volatility rises to 31%, the bid price and ask price would increase to $1.75 and $1.80, respectively (1 x $0.25 added to the bid-ask spread). Conversely, if the implied volatility drops by 5%, the bid price and ask price should theoretically decrease by $1.25, dropping to $0.25 and $0.30, respectively (5 x $0.25 = $1.25, subtracted from $1.50 and $1.55). Increased volatility makes option prices more expensive, while decreased volatility lowers option prices.
Related Terms: option pricing, implied volatility, Greeks, bid-ask spread.
