What Is Option Vega?

Vega, the only one of the Greeks not represented by a Greek letter, is the estimate of the change in the theoretical value of an option for a 1-percentage point (1%) increase in implied volatility. Vega thus measures the sensitivity of the price of an option to changes in volatility. Higher volatility or IV means higher option prices, lower volatility or IV means lower option prices, and vega is the measure of the impact of volatility on option price. The reason is as noted above: higher volatility means greater price swings in the stock price, which translates into a greater likelihood for an option to make money by expiration.

An increase in volatility will increase the prices of all the options on a stock, and a decrease in volatility causes all the options to decrease in value. Vega simply is the measure of these changes due to the effect of IV. A change in implied volatility will affect both calls and puts the same way. The vega of a long option position (both call and put) is always positive; that of short calls and puts is negative.

Figure 5.20 sets forth some of the critical hallmarks of vega:

            Figure 5.20

Vega: Effects of Strike and Expiration Month

Vega and

Strike Price

ATM options have the greatest vega, thus their premiums are the most sensitive to volatility changes.

 

The further an option goes ITM or OTM, the smaller its vega will be. As volatility falls, vega decreases for in-the-money and out-of-the-money options; vega is unchanged for at-the-money options.

Vega and Time

to Expiration

As time elapses, option vega decreases – that is, decays with time. Time amplifies the effect of volatility changes. As a result, vega is greater for long-dated options than for short dated options.

 

Since LEAPS have a high vega, a rise in volatility (or IV) would raise the level of time value on a long LEAPS position.

What the above table tells us is that changes in vega have the greatest effect upon the longer-dated ATM options, far less on long-term ITM and OTM options and comparatively little on short-term options.

Vega Example: Assume Nucor (NUE) stock is $30 per share and current volatility is 70%; the premium for the ATM 30 Call five months out is $7.30 and the long call’s vega is +.25. Here is the effect that a change in implied volatility on Nucor options could be expected to have on the long-dated call’s premium, given the +.25 vega:

  • Volatility rises to 41% (1% gain) = $7.55 $0.25 Gain
  • Volatility falls to 39% (1% fall)   = $7.05 $0.25 Loss

In this example, the long-dated General Motors OTM call will lose $0.25 in price for every 1-point fall in implied volatility. It likewise will gain $0.25 in price for every point implied volatility rises. Vega causes premium to move in response to changes in implied volatility, not stock price. A 20-point fall in IV would seriously degrade the call’s premium, by $5.00, unless vega itself changed.

For this reason, buying long-term ATM options loaded with high implied volatility is a poor strategy, although selling them can be a good strategy. One buying a long-term protective put when implied volatility and vega are high likewise is a poor strategy.

The effect on long-dated ITM and OTM options is far less, but still is not inconsiderable when IV is quite high.

Vega can cause changes in an option’s price based upon changes in option implied volatility, even though the stock price does not change. As with other Greeks, vega affects only time value premium, not intrinsic value.

Even those like myself who do not use vega directly in covered writing or option trading still can benefit from an understanding of how its operation can affect option prices. Note that the Greek letter tau (τ) sometimes is used instead of vega and means the same thing.

You can learn more about options in this options trading for dummies article.

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