Options generally benefit from rising volatility, although some options more than others.
Vega measures an option’s sensitivity to volatility – by how many dollars the option premium will change if implied volatility increases by one percentage point and other things remain the same.
Vega is a ratio of price change (in dollars) to volatility change (in percentage points) its units are dollars per percentage point.
Vega is the Greek that measures an option’s sensitivity to implied volatility.
It is the change in the option’s price for a one-point change in implied volatility. Traders usually refer to the volatility without the decimal point.
For example, volatility at 14% would commonly be referred to as “vol at 14″.
Volatility should not be confused with Vega.
Volatility is either the historical or expected bounciness of the underlying future.
Historical volatility is volatility in the past and is therefore known.
Expected volatility is unknown volatility in the futures contract that feeds into the option price as implied volatility.
Example - Vega
Vega is the sensitivity of a particular option to changes in implied volatility.
For example, if the value of an option is 7.50, implied volatility is at 20 and the option has a Vega of .12.
Assume that implied volatility moves from 20 to 21.5. This is a 1.5 volatility increase.
The option price will increase by 1.5 x .12 = .18 to 7.68.
Conversely, if volatility dropped from 20 to 18. This two-point decrease times .12 equals .24, making the option premium 7.26.
Vega is the highest when the underlying price is near the option’s strike price. Vega declines as the option approaches expiration. The more time to expiration, the more Vega in the option.
Vega Values
All options become more valuable when volatility rises. Therefore, vega is positive for both calls and puts.
There is no theoretical upper limit on the values vega can reach.
Of the two components of option premium, volatility (and vega) only affects time value; it has no effect on intrinsic value.
Therefore, as a rule of thumb, options with more time value have higher vega.
Vega is negative for all short option positions. Positions in the underlying security have zero vega.
Vega and Option Moneyness
At the money options have greatest time value and highest vega. Options further away from the money to either side (in the money, out of the money) have less time value and lower vega.
While at the money options have greatest vega in absolute terms, out of the money options have greatest vega as percentage of their total (intrinsic + time) value, as their premium consists of time value only.
Longer term out of the money options can be good vehicles for speculating on volatility (high vega for relatively low cost), with relatively small exposure to direction (delta and gamma).
Vega and Time to Expiration
Longer dated options are more sensitive to volatility, because over a longer time period, volatility has more time to act in the option holder’s favor.
The more time to expiration, the higher vega.
As an option approaches expiration and loses time value, its vega goes down.
Vega and Volatility
When implied volatility changes, vega itself can change.
Not so much for at the money options – their vega is relatively stable over a wide range of volatility levels.
Options deeper in the money or further out of the money can have very low vega when implied volatility is low (and their time value is near zero).
As volatility rises, their vega gradually increases, although it never exceeds the vega of at the money options with the same expiration and underlying.
In other words, when volatility is high, the differences in vega across a wide range of strikes are quite small (although at the money strikes still have highest vega).
When volatility declines, the differences become much bigger, mainly due to far out of the money and deep in the money strikes’ vega falling, while at the money vega stays more or less the same.
Conclusion
Vega measures how option price will change if implied volatility rises by one percentage point.
All options have positive vega – gain value with rising volatility.
Vega is greatest at the money (but out of the money in percentage terms).
