What is option vega?
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The vega of an option tells us the change in the option’s value for a change in implied volatility. Typically, it is normalized so that vega tells us the change in option value for a 1% change in the level of implied volatility. For example, an option may have a value of $3.15 and a vega of 0.10. If implied volatility is 25% and it increases to 26%, then we might expect the option’s value to increase to $3.25, simply by the definition of vega.
Vega is useful to option traders because implied volatility tends not to be static. In fact, its movement is one of the main drivers of change in an option’s value and so vega allows the option trader to quantify this particular risk. Knowing the vega of his portfolio, the option trader knows the extent to which he is exposed to changes in implied volatility.
How does vega vary from option to option? Vega is generally larger in options that have a longer time until they expire, other things being equal. Why is this? Well, an increase in implied volatility effectively means that the underlying product is expected to be more volatile during the option’s life. This tends to increase the value of an option (because it increases its likelihood of expiring in-the-money). Now for options that still have a long life ahead of them, this increase in volatility will be more beneficial than say for options that expire in the next 10 minutes. In other words, longer term options are more sensitive to changes in implied volatility, which is just another way of saying that they have higher vega.
The strike price of an option can also affect the amount of vega it has. More precisely, the relative closeness of the strike price to the spot price is what matters. Options that are very far out-of-the-money tend to have little or no vega. This is because a small increase in implied volatility makes very little difference as to whether or not they are likely to expire in-the-money. i.e. their value is not affected much one way or the other by changes in implied vol (which means they must have little or no vega). But at-the-money options are far more sensitive to changes in implied volatility. Higher volatility greatly increases their chances of moving in-the-money, so their value is sensitive to changes in implied volatility i.e. they have more vega.
A third factor that influences the amount of vega an option has, is the level of implied volatility itself. Greater implied volatility tends to make out-of-the-money options resemble at-the-money options more closely (because in a sense they are becoming closer to being at-the-money; with infinite implied volatility, every option is an at-the-money). In consequence, the higher the implied volatility, in general, the higher an option’s vega. Note one exception here is the at-the-money options themselves. Their vega is largely independent of the level of implied volatility.
How do option traders use vega? Vega is one of the most important risk metrics an option trader relies upon. It is used to gauge the portfolio’s overall sensitivity to changes in implied volatility, one of the largest risks the option traders faces. For example, a trader with $1 million of vega knows he will make or lose $1m dollars for every 1% change in implied volatility. Vega can be used to compare risk across products and time frames although greater care has to be taken here. With options struck on different underlyings and with different times to expiration, the comparison is only valid when the volatility of implied volatility is comparable. Nevertheless, the raw vega of a position is often used as a very rough guide to the overall risk.
Vega can also be used in pricing and comparing options. If for example an option with 10 vega trades 10 cents above a trader’s theoretical value, this indicates an implied volatility level 1% higher than his pricing model is using. If then a second option with say 5 vega trades 7 cents over the same pricing model’s value, then this is more than 1%. In other words, in implied volatility terms, this is a more expensive level in implied volatility.
Vega is one of the core option Greeks used by traders to risk manage their option portfolio and to compare option valuations. And of course, you can learn how to use it for yourself Volcube’s option market simulator.
Volcube is an options education technology company, used by option traders around the world to practise and learn option trading techniques.