Vega

Understanding Vega in Options

What is vega?

Vega measures how much an option’s price is expected to change for a 1% change in the implied volatility of the underlying asset. It applies to both calls and puts — when implied volatility rises, option premiums typically increase; when it falls, premiums decrease.

Why vega matters

• It quantifies sensitivity to volatility, letting traders profit from or hedge against volatility moves even if the underlying price stays unchanged.
• At‑the‑money options and longer‑dated options usually have the largest vegas because more time and proximity to the strike increase the value of potential price swings.
• Vega declines as expiration approaches because there is less time for significant price movement.

How vega affects option pricing (simple rule)

If an option has vega = 0.20, a 1% increase in implied volatility increases the option price by $0.20 per share (or $20 per standard 100‑share contract). A 1% decline in volatility reduces the option price by the same amount.

Example:
– Vega = 0.20
– Volatility rises 5% → option increases by 0.20 × 5 = $1.00 per share → $100 per contract

Practical example: AAPL call

• Stock price: $225 (at‑the‑money)
• Option premium: $10.00 per share
• Vega: 0.20
• If implied volatility rises from 25% to 30% (a 5% increase): option premium ≈ $11.00 → total value $1,100 (gain $100).
• If implied volatility falls from 25% to 20%: option premium ≈ $9.00 → total value $900 (loss $100).

Vega-neutral strategies

Vega‑neutral positions are designed to minimize exposure to volatility changes, letting traders focus on directional moves or other risks.

Common approaches:
– Ratio spreads: combine long and short options so positive and negative vega exposures offset. Example: buy 1 ATM option (vega 0.30) and sell 2 OTM options (each vega 0.15) → net vega = 0.
– Calendar spreads: sell near-term options and buy longer-term ones to balance the higher vega of long-dated options against lower vega of short-dated options.

Notes:
– Maintaining vega neutrality requires active monitoring and rebalancing as vega profiles shift with time, price, and volatility.
– These strategies are more advanced and typically need careful position sizing and modeling.

Vega, implied volatility, and market sentiment

• Implied volatility (IV) reflects the market’s expectation of future price swings; vega measures how option prices respond to changes in IV.
• High vega across many options often signals market concern (e.g., around earnings or macro events). The VIX is an index of implied volatility for S&P 500 options and is commonly called the market’s “fear gauge.”
• Low vega generally indicates calmer expectations.

Vega vs. theta (volatility sensitivity vs. time decay)

• Vega: sensitivity of option price to changes in implied volatility.
• Theta: rate at which an option’s price decays as time passes (time decay).
• Relationship: more time until expiration tends to increase vega (more uncertainty) but reduces theta. As expiration nears, theta accelerates and vega wanes because there’s less time for volatility to matter.

Practical tips

• Use vega to size positions when you expect volatility to change.
• Consider vega when selecting strikes and expirations: ATM and longer expirations amplify vega exposure.
• For directional trades where volatility is a risk, consider hedging with vega‑neutral structures.
• Monitor vega as expiration approaches; its decline can materially affect option values.

Why the name “vega”?

“Vega” is a pseudo‑Greek term adopted by practitioners to label volatility sensitivity. It is not a Greek letter but is now standard terminology in options analysis.

Key takeaways

• Vega shows how an option’s price changes per 1% move in implied volatility.
• Both calls and puts have positive vega; at‑the‑money and longer‑dated options have the highest vega.
• Vega and theta interact: more time increases vega but reduces theta; nearer expiration the reverse is true.
• Vega‑neutral strategies can isolate directional exposure from volatility risk but require active management.

Sources
– CME Group Education — Options Vega (The Greeks)
– John C. Hull, Options, Futures, and Other Derivatives