Vega in options - What it is, Formula, Example & Importance

Vega

What is Vega in option trading ?

Vega quantifies how sensitive an option's price is to changes in the volatility of the underlying asset. It indicates how much the price of an option is expected to change in response to a 1% change in the implied volatility of the underlying security.

Key Points About Vega:

Sensitivity to Volatility: Vega reflects how much an option’s price will increase or decrease when the implied volatility changes.
Positive for Both Calls and Puts: Vega is always a positive number for both call and put options because higher volatility typically increases the likelihood of an option finishing in-the-money, making the option more valuable.
At-the-Money Options Have Higher Vega: Options that are at-the-money (ATM) or near the strike price tend to have the highest Vega because they are most affected by changes in volatility. Far out-of-the-money (OTM) or in-the-money (ITM) options have lower Vega.
Time Impact: Vega decreases as an option approaches expiration. As the time to expiry shortens, the effect of volatility on the option’s price diminishes, leading to a decline in Vega.

Vega Formula:

While Vega itself isn't derived from a simple formula like delta or theta, it can be calculated using more complex models like the Black-Scholes model. It's expressed in dollar terms for the option premium and shows how much the option's price will change with each 1% change in implied volatility.

Example:
If an option has a Vega of 0.10, and implied volatility increases by 1%, the option price would increase by 0.10 units (which could represent $0.10 if quoted in dollars).

Importance of Vega:

Volatility Trading: Traders focused on volatility (e.g., in strategies like straddles or strangles) rely heavily on Vega to anticipate how much their options positions will benefit from changes in volatility.
Risk Management: Understanding Vega helps in managing the risk associated with changes in market volatility, which can be particularly crucial during earnings reports or significant news events that affect market sentiment.