What Is Vega in Options Trading?
Vega is one of the Greeks — along with delta, theta, and gamma. And the Greeks, itself, is a set of indicators that quantitative analysts and traders use to measure the effect of various factors on prices of options contracts. Traders can use the Greeks to hedge against risks involved in trading options. Each indicator in the Greeks helps analysts to understand the level of risk, volatility, price direction, value over time, and interest rate of a particular options contract.
As a unit of measure, vega tries to assess, theoretically, the amount that a security’s price will change with every percentage point that its price fluctuates. So vega reflects how sensitive a contract is to changes in the price of its underlying security. When an underlying asset of an options contract has significant and frequent price changes, then it has high volatility, which also makes the contract more expensive.
How Vega Works
Vega changes over time as the price of the underlying asset changes and the contract moves closer to its expiration date. Because vega is always changing, investors tend to track it on an ongoing basis while they are invested in an options contract.
When options still have time before they expire, the vega is said to be positive. But when an options contract nears its expiration date, then vega decreases and becomes negative. This is because premiums are higher for future options than they are for options that are close to expiring. When an option’s vega is higher than the amount of the bid-ask spread, the option has what is known as a competitive spread. If vega is lower than the bid-ask spread, then the spread is not competitive.
Vega is a derivative of implied volatility.
The term, implied volatility is simply an estimate of where the price of an underlying security may be now, was in the past, or will be going forward. In pricing options, implied volatility is mostly used to predict future price fluctuations. Traders sometimes use a sigma symbol (𝞂) to represent implied volatility.
Traders use options pricing models to calculate implied volatility. These models try to estimate the speed and amount that an underlying security’s price changes — its volatility. As the volatility of the underlying asset shifts, the vega also changes. Pricing models can estimate volatility for present, past, and future market conditions. But, as the calculation is just a theoretical prediction, so the actual future volatility of the security may differ.
Characteristics of Vega
• Vega relates to the extrinsic value of an option, not its intrinsic value.
• Vega is always positive when an investor purchases calls or puts.
• It Is negative when writing options.
• Vega is higher when there is more time until the option expires.
• It’s lower when the option is close to expiring.
• When the option is at the money, vega is highest.
• When the option is in- or out-of-the-money, vega decreases. In other words, vega is lower when the market price of the underlying security is farther from the option strike price.
• When implied volatility increases, the option premium increases.
• When implied volatility decreases, the option premium decreases.
• The effect vega has on options trading is based on various factors that affect the option’s price.
• When gamma is high, vega is generally also high.
• Vega shows an investor the amount that an option should theoretically change for every percentage its underlying security’s volatility changes.
• Vega can also be calculated for an entire portfolio of options to understand how it is influenced by implied volatility.
What Does Vega Show?
Vega shows the theoretical amount that an option’s price could change with every 1% change in implied volatility of the underlying asset. It can also be used to show the amount that an option’s price might change based on the volatility of the underlying security — that is, how often and how much the security’s price could change.
Traders generally omit the percentage symbol when referring to vega, or volatility. And some analysts, too, display it without a percentage symbol or decimal point. In that case, a volatility of 16% would be displayed as “vol at 16.”
Vega Options Example
Let’s say stock XYZ has a market price of $50 per share in February. There is a call option with a March expiration date with a price of $52.50. The option has a bid price of $1.50 and an ask price of $1.55.
The option’s vega is 0.25, and it has an implied volatility of 30%. Because vega is higher than the bid-ask spread, this is known as a competitive spread. A competitive spread does not mean the trade will be profitable or that it is automatically a good trade to enter into, but it is a positive sign.
The implied volatility of the underlying security increases to 31%. This changes the option’s bid price to $1.75 and changes the ask price to $1.80. This is calculated as
Conversely, if the implied volatility goes down 5%, the bid price would decrease to $0.25 and the ask price decreases to $0.30.
How Can Traders Use Vega in Real-Life?
Vega tends to be less popular with investors than the other Greeks (Delta, Theta, and Gamma) mostly because it can be difficult to understand. But vega has a significant effect on options prices, so it is a very useful analytic tool.
Benefits of Vega
If investors take the time to understand implied volatility and its effect on options prices, they’ll find that vega can be a useful tool for making predictions about future options price movements. It also helps with understanding the risks of trading different types of options contracts. Looking at the implied volatility of options can even guide investors as they choose which options to buy and sell. Some traders even utilize changes in volatility as part of their investing plan — with strategies like the long straddle and short straddle. Vega plays a key role in using these options trading strategies.
Vega Neutral: Another Strategy
For traders who want to limit their risk in options trading, the vega neutral strategy helps them hedge against the implied volatility in the market of the underlying security. Traders use the vega neutral strategy by taking both long and short option positions on a number of options. By doing this, they create a balanced portfolio that has an average vega of around zero. The zero value means that their options portfolio will not be affected by changes in the implied volatility of the underlying security, thereby reducing the portfolio’s level of risk.
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Vega, one of the Greeks, along with the concept of implied volatility relate to advanced trading techniques. Trading options is usually appropriate for experienced traders.
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