In relation to options, Vega represents the amount an option’s price will change with a 1% change in the implied volatility of the underlying security.
This article will give investors a better understanding of what Vega is, and will show how Vega is used in an example. Knowing what Vega is and how it affects an option’s price will be helpful in an investor’s own options trading success.
Implied volatility is a measure of how volatile a security’s price may be in the future. High implied volatility means that the security is expected to have large fluctuations in its price, or that there is uncertainty related to the security. Low implied volatility means that the security is not expected to have large fluctuations in its price, or that there is little uncertainty related to the security.
To note again, Vega is the amount the price of the option will change when there is a 1% change in the implied volatility.
Options that have a longer amount of time until expiration tend to have a higher Vega value than options that have a shorter amount of time until expiration. This is because longer-term options have a higher premium than shorter-term options. So, a 1% change in the implied volatility of the longer-term options will have a greater price change than a 1% change in the implied volatility of the shorter-term options.
Let’s look at an example of the Vega value being used.
Stock ABC is trading at $40. A call option has six months until expiration with an implied volatility of 20% and a Vega of .10. The option’s price is $3.
If implied volatility rises from 20% to 22%, then the option’s price would be expected to rise to $3.20 (2 X .10 = .20; this is added onto the original price of the option).
If implied volatility decreases from 20% to 17%, then the option’s price would be expected to decrease to $2.70 (3 X .10 = .30; the original price is subtracted by this amount).
Understanding Vega will allow an investor to see how much an option’s price will change as the implied volatility of the option changes by 1%. This is a useful skill to have when it comes to options trading.