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Published On: Sat, Dec 8th, 2012

Options Vega Explained

Options Vega is one of the so-called Greeks of options trading. The others are Delta,

Gamma, Rho and Theta. Apart from Delta, Vega is probably the most important of the Greeks
for an options trader to have a basic understanding of.

The technical definition of Vega is that it is the change in the price of an option as a result of a
1 percent change in the volatility of the underling trading asset (stock, currency, commodity).

Example:

Shares of Company ABC are trading at $92 at a given moment and a 1-month call option
is selling for $4. Let us further assume that the Vega of this option is 0.10 and that the
underlying volatility is 20%.

If the volatility of the underlying stock should now increase by 1% to 21%, if everything else
remains the same, the price of the option should increase from $4 to $4 + 0.10 = $4.10.

If the volatility had dropped by 1%, however, the price of the option would have dropped from
$4 to $4 – $0.10 = $3.90.

Vega and Options Moneyness

Fig. 8.24(a) below is a chart showing the Vega of a typical option for different strike prices.

 

 

 

 

 

Fig. 8.24(a)

From this chart it is clear that

a) ATM options have the highest Vega and
b) Vega tapers off as the option becomes further OTM or ITM

The best way to explain this is that a very far OTM option, which is virtually worthless, is very
unlikely to suddenly become ITM no matter how high the volatility of the underlying asset.
A deep ITM option on the other hand is very unlikely to suddenly become worthless, even if
the volatility of the underlying asset drops sharply – because it already has a lot of intrinsic
value.

What makes Vega so important?

For both options buyers and options sellers Vega is important because, together with Delta, it
has a major effect on the price of an option.

Consider the following scenario: Going back to our example above, trader John bought 2
contracts of company ABC call options at $4 per option while the volatility of the stocks were
20%. He was not aware of the fact that the company would soon make an announcement that
could impact its profits for year to come.

When the announcement is made the share price shoots up and the volatility increases from
20% to 40%. Given the 0.10 Vega in our example, the price of his options would increase
from $4 to $4 + (40-20) x $0.10 = $4 + $2 = $6. He will therefore be able to exit his position
with a profit of 50% based on the initial cost of the options.

Vega and time

 

 

 

 

 

 

 

 

 

 

The longer the time to expiry of an option, the higher the option’s Vega. Fig. 8.24(b) is a chart
showing the time/Vega trade-off for a hypothetical option. The blue line shows Vega for a 60-
day option and the pink line shows Vega for a 7-day option.

This simply reflects the fact that longer term options have higher time value (or extrinsic value) than short term ones, i.e. an increase in volatility is more likely to result in the option

ending ITM than with a short term option.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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