What is Vega?
A metric known as Vega assesses an option’s price sensitivity to variations in the underlying asset’s volatility. The amount that an option contract’s price fluctuates in response to a 1% shift in the underlying asset’s implied volatility is known as Vega.
Overview of Vega
The quantity and rate of price fluctuations are measured by volatility, which may be influenced by a trading instrument’s past, present, and predicted price movements. Options with a future date have positive Vega, but those with an immediate expiration date have negative Vega. These numbers have a straightforward explanation. Option holders often allocate higher premiums to future expiring options than passing ones.
Vega fluctuates in response to significant fluctuations in the underlying asset’s price (more volatility), decreasing as the option’s expiry date draws near. Among the Greeks used in options analysis is Vega. Some traders use them as a hedge against implied volatility as well. An option is considered to provide a competitive spread if its Vega is higher than the bid-ask spread. Moreover, the reverse is true. Additionally, Vega informs us of the potential range of the option’s price in response to variations in the underlying asset’s volatility.
Presumptive Volatility
Vega calculates the potential price change for every percentage point that implies volatility changes. An option pricing model is used to compute implied volatility, the amount that current market prices predict an underlying asset’s future volatility. Implied volatility could differ from actual future volatility since it is a prediction.
Vega movements are only sometimes consistent, just as price movements are. Vega evolves. As a result, the traders that use it keep a close eye on it. As previously discussed, options getting close to expiration often have lower volatility than comparable options further away from expiration.
Vega example
An option is considered to provide a competitive spread if its Vega is higher than the bid-ask spread. Moreover, the reverse is true.
Additionally, Vega informs us of the potential range of the option’s price in response to variations in the underlying asset’s volatility.
Let’s say that the hypothetical company ABC is trading in January at $50 per share and that there is a $52.50 call option expiring in February with a bid price of $1.50 and an asking price of $1.55. Please assume that the option’s implied volatility is 30% and its Vega is 0.25. The spread on the call options is competitive; it is less than the Vega. This does not imply that the option will be profitable for the option buyer or that it is a brilliant deal. This is just one factor to consider; an excessive spread may make entering and exiting transactions more difficult or expensive.
The option’s bid and ask prices should rise to $1.75 and $1.80 if the implied volatility increases to 31% (1 x $0.25 added to the bid-ask spread). The bid and ask prices should fall to $0.25 by $0.30 (5 x $0.25 = $1.25, which is removed from $1.50 and $1.55) if the implied volatility drops by 5%. When volatility rises, options become more costly to trade; when volatility falls, options become less expensive to exchange.
Conclusion
- Vega calculates the value of an option price based on variations in the underlying asset’s implied volatility.
- Long-term options have positive Vega, but short-term options have negative Vega.
