Investing > Vega Options Explained

Vega Options Explained

Although Vega is one of the most important metrics for options trading, it is surprisingly simple to master.

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Updated July 29, 2022

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Have you ever considered getting into options?

Sure, derivatives might have a terrible reputation, but that is slowly wearing off – chiefly because it is in large part unfounded. In recent years, the retail options trading market has seen a rapid increase in activity. Still, this doesn’t mean that one should blindly rush in.

If properly executed, options trading strategies are no more risky than trading stocks or ETFs. However, “if” is the operative word here – and that “if” implies a lot of effort and research. However, the first step is always the hardest to take – but that’s why we’re here to help.

Options contracts derive their value from the value of an underlying asset. An understanding of what affects asset prices is key for successful options trading – but it isn’t enough on its own. There is an entirely separate list of metrics that have a large impact on options contracts prices – and they are known as the Greeks.

Knowing the Greeks like the back of one’s hand is essential for mastering options trading. Thankfully, although these metrics might seem Greek (pun intended) to the average layperson, they are actually quite simple. All of them measure the options contract’s sensitivity to changes in some other metrics.

Today’s topic will be Vega – the Greek that measures an options contract’s sensitivity to changes in implied volatility. To be more precise, Vega measures how an option will react to a 1% change in the implied volatility of the underlying asset. Not only is Vega simple to understand, but this metric is essential for many options trading strategies – to put it bluntly, this isn’t an elective subject.

What you’ll learn
  • How Do Options Work?
  • What is Vega in Options?
  • How is Vega Being Used?
  • Calculating the Vega
  • An Example of Options Vega
  • What is Vega Neutral?
  • Quiz Time: Test Your Knowledge
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

How Do Options Work? 👷‍♂️

Options or options contracts are derivatives – financial instruments that are a tad bit more complicated than traditional securities such as stocks. Derivatives derive their value from an underlying asset – if the value of an asset changes, then the value of the derivative also changes.

Options contracts, in particular, are derivatives that give investors the right (but not the obligation) to buy or sell a security at a predetermined price before a predetermined time. An option contract that gives the right to buy a security is called a call option – while an options contract that gives the right to sell a security is called a put option.

A quick summary of how call and put options work.
Put and call options are the two types of options contracts available for stocks and other assets. Their price movements depend on the price movements of an underlying security.

Options are quite accessible and the easiest way to trade derivatives, and although derivatives as a whole get a bad reputation, options can actually be quite beneficial to retail investors. They offer numerous benefits – for one, investing by using options requires much less capital than actually buying stocks. In essence, when investing in options, traders are betting on the direction in which the price of a security will move.

To illustrate, let’s use a simple example. An investor thinks that shares of  Home Depot (NYSE:HD), which are trading at $290, will see an increase in price due to dropping lumber prices and a strong balance sheet. But forking up $290 per share is expensive – so instead, the investor purchases call options for Home Depot stock.

Now, options are cheaper than stocks – but they still come with some expenses. This is referred to as a premium. For this example, let’s say that the premium for the contract is $5 per share and that the investor bought 100 options contracts.

With $500 invested, the price of the stock would have to move up by just $5 for the investor to break even. If the price increased to say, $330, an increase of $40, then the investor would earn $35 for every options contract – for a grand total of $3500.

What is Vega in Options? 🤔

As mentioned, options contracts derive their value from the value of an underlying asset. However, there are also other factors and metrics at play – without which a successful options trading strategy cannot be executed.

Keep in mind that using a simple call or put option is a one-leg strategy – there are plenty of strategies, such as straddles, strangles, and the iron condor, which rely on the simultaneous purchasing of both call and put options at either the same or different strike price and expiry date. Without a solid overview of all metrics that affect an options price, these advanced strategies will remain out of reach.

Chief among these metrics are the Greeks – Delta, Gamma, Theta, and today’s topic – Vega. The Greeks signify an options contract’s sensitivity to various factors – with Vega representing an options contract’s sensitivity to changes in implied volatility in the underlying asset.

Vega Fundamentals 📜

To understand Vega, first we have to deal with what it measures – sensitivity to implied volatility. In order to grasp the concept of implied volatility, we have to deal with volatility. Volatility, also referred to as beta, represents the intensity, frequency, and speed of price changes in a particular asset, when compared to an index or a benchmark.

A volatility or beta of 1 implies that the asset in question is perfectly correlated with the index or benchmark – when it rises by 1%, the asset rises by 1% – when it drops by 1%, the asset drops by 1%.

Beta or historic volatility is a measure that looks backward – by using statistical data to determine what actually occurred in the past with regard to a stock’s price fluctuations. Implied volatility, which is the metric that vega is based on, is forward-looking – it is an estimation of the probability and probable intensity of future price movements.

Implied Volatility and Vega 📚

So, now that we have a working knowledge of implied volatility, we can move on to the meat of the matter – Vega. Vega measures how an options contract’s price will change in the event of a 1% change in implied volatility. Implied volatility itself is calculated by way of an options pricing model. Keep in mind, however, that implied volatility is still a projection – actual volatility in the future might exceed or fall short of this projection.

An overview of the various factors that have an effect on implied volatility.
There are multiple factors that affect volatility. Some depend on the conditions of the options contract, while others are determined by the markets.

However, nothing is static in the world of finance – Vega isn’t some fixed measure. Instead, vega changes over time – the closer an options contract is to expiry, the lower the vega. Therefore, it is essential for options traders to keep an eye on this important metric.

How is Vega Being Used? 👨‍🏫

Vega has a variety of uses in options trading, but it is often maligned and underappreciated. Most traders pay greater attention to the other Greeks – but this is a huge mistake, as apart from Delta, Vega is probably the most important metric of all.

Although, admittedly, Vega is slightly more complicated than the other Greeks, putting in the effort to understand it is well worth it. So, let’s move on to the three most common uses of this options trading metric.

Long Options Vega 📈

Long options have positive vega values. Traders who go long in options or purchase options have an interest in the options’ premium rising – with a positive Vega value, long options positions benefit from an increase in implied volatility. 

This, of course, means that in the event of implied volatility dropping, the value of a long options contract will also decrease. Long options portfolios are said to have positive exposure to implied volatility.

Short Options Vega 📉

Short options have negative Vega values. Traders who go short or sell options contracts have an interest in the options premium decreasing. With a negative Vega value, a short options position benefits from a decrease in implied volatility. 

Unlike long options contracts, short options contracts lose value in the case that implied volatility rises. Short options portfolios are said to have negative exposure or vulnerability to implied volatility.

Volatility Measure 📊

One innovative way that Vega can be used is to measure the volatility of an options trade. This might sound confusing – but it is actually rather simple. Multi-leg options strategies, which include most advanced options strategies, rely on purchasing multiple options contracts – and this is often done by going long and short at the same time.

For example, going long on a stock with an options contract that has a vega of +70 while simultaneously going short on the same stock with a contract that has a vega of -40 leads to a net vega of 70 – 40 = +30. This means that the trade, taken in its entirety, has positive volatility exposure and is long Vega.

Calculating the Vega 🧮

Alright – we’re well aware that math might not be everyone’s cup of tea, but it is essential in the case of Vega. To calculate this metric, there are a couple of formulas to keep in mind. However, don’t panic just yet – all of the top-rated brokerages for options trading have tools that automate this process, so there’s really no need to memorize this stuff.

On the most fundamental level, the Vega of an option can be described using this formula:

ν = ∂V / ∂σ

Where V is Vega, ∂ is change, V is the price of the option, and σ represents volatility. There are other formulas for calculating vega, but these factor in various other elements, and are far too complex to include or explain in this guide.

An Example of Options Vega 📝

To bring all of this stuff closer to home, let’s make use of a couple of easy-to-understand examples. In our hypothetical scenario, an options contract has a bid price of $2.35 and an ask price of $2.45. The vega of the contract is 0.6, and implied volatility is currently at 20%.

If implied volatility rose by 1%, up to a total of 21%, then both the bid price and ask price would see an increase of $0.6, equal to the vega, for a new bid/ask price of $2.95 and $3.05, respectively. 

If, however, implied volatility rose by 3% from 20% to 23%, then the new bid and ask prices would increase by three times the Vega of the contract, or $1.8 in this case – for a new bid/ask price of $4.15/$4.25.

Conversely, if implied volatility were to drop from 20% to 18%, then $1.2 would be subtracted from the bid/ask price, for a new bid/ask price of $1.15 and $1.25.

What is Vega Neutral? 📖

Vega is a versatile option – and nothing exemplifies this more than the risk-management strategy referred to as Vega neutral. In short, Vega neutral is an approach that seeks to create an options portfolio where the sum total of Vega is equal to zero.

In order to construct such a portfolio, investors will have to utilize options trading in both long positions and short positions. So, that sounds simple enough – but how does such a portfolio profit?

Well, the bid-ask spread is the thing that leads to profits in this case. On top of that, there is the possibility of a skew in the volatilities of the calls and puts. Keep in mind that, with Vega at zero, any changes to implied volatility won’t cause gains – but they won’t cause losses either.

How to Make a Vega-Neutral Portfolio 🏗

First of all – one should keep in mind that constructing a Vega-neutral portfolio is quite an advanced strategy. However, our goal is always to make a one-stop guide for all needs regarding a topic, so we’re going to cover the process of creating such a portfolio.

In order to explain, we need to use a hypothetical example. Let’s say that an investor currently owns 400 lots of puts with a strike price of $30. The vega for each unit in this case is 4, meaning that, as it currently stands, the entire portfolio has a vega of 400×4=1600

In order to reach Vega neutrality, an investor will look for an opportunity to take a short position on the same asset, but with a different strike price in order to eliminate risk. Let’s say that they find puts with a strike price of $25, with a Vega of 2 per unit. In that case, the investor would need to short 800 lots for the portfolio to be Vega neutral. The math looks like this: 

(400×4) – (800×2) 
= 1600 – 1600 
= 0

Keep in mind that this is a simplified example used to explain the mechanisms behind a Vega-neutral portfolio. In practice, pulling this off is much more complex, as options trading is subject to a variety of factors not included here.

Quiz Time: Test Your Knowledge 📃

Alright – let’s put everything that we’ve gone through in this guide to the test. This quiz will contain five simple questions, which will serve as a solid indicator of whether or not the topic at hand has been understood. Don’t feel any pressure – this stuff isn’t exactly the simplest thing out there, so it is perfectly fine to retake the test and take all the time needed to truly absorb the knowledge.

Question 1:

An options contract with a bid/ask price of $14.95 / $15.25 has a Vega of 0.34. The current implied volatility is 15%. What would happen to the bid/ask price of the contract if implied volatility rose by 4%?

Hint: Change in implied volatility x Vega = Price change

1) 4 x 0.34 = 1.36

$14.95 + 1.36 = $16.31
$15.25 + 1.36 = $16.61

The new bid/ask price is $16.31/$16.61.

Question 2: 

An options contract has an implied volatility of 8%. That implied volatility rises by 2%, and the price of the options contract increases by $0.24. What is the vega of the options contract?

Hint: Price change of options contract / change in implied volatility = Vega

V= 0.24 / 2 = 0.12

Question 3:

An options contract with a bid/ask price of $6.35 / $6.55 has a Vega of 0.54. The current implied volatility is 23% What would happen to the bid/ask price of the contract if implied volatility decreased by 8%?

Hint: Change in implied volatility x Vega = Price change

8 x 0.54 = 4.32

$6.35 – 4.32 = 2.03
$6.55 – 4.32 = 2.23

The new bid/ask price is $2.03/$2.23

Question 4:

A multi-leg options strategy has been put into play. The long portion of the strategy has a Vega of +50. The short portion of the strategy has a Vega of -70. What is the volatility exposure of the strategy?

Hint: Positive volatility exposure – Negative volatility exposure = Total volatility exposure

50 – 70 = -20

The overall strategy has a Vega of -20, and is therefore vulnerable to implied volatility, or in other words, it has negative exposure to implied volatility.

Question 5:

An investor currently owns 150 lots, each with a vega of 2. What sort of short position should be taken to ensure a Vega-neutral portfolio?

150 x 2 = 300

Hint: The short position has to have an equal yet opposite Vega to the long position – in other words, -300 Vega.

The initial long position has a Vega of 300. In order to achieve a Vega-neutral portfolio, the short position should have a Vega of -300. This can be accomplished in a variety of ways, but for the sake of example, let’s say that purchasing 100 lots, each with a Vega of -3 is sufficient.

Final Word 🏁

Congratulations on reaching the end of this guide. However daunting getting into options and derivatives might seem at first glance, it really isn’t that difficult. Provided that investors take their time, apply themselves to learning about topics like the Greeks and Vega, and practice with a demo account before setting off, options are a great way to profit from various goings-on in the market.

More to the point, with just a little bit of effort and math, investors can attain a much greater understanding of what drives the prices of options contracts to change. When looking at how big of an advantage over the competition that is, it is a small price to pay.

Vega Options: FAQs

  • What Does Vega Mean in Options?

    In options trading, vega represents an options contract’s sensitivity, or how its price will change, in the event of a 1% change in the underlying asset’s implied volatility.

  • Is High Vega Good in Options?

    High vega is good for long options positions - it is not good for short options positions.

  • How Does Vega Affect Options?

    Vega denotes how sensitive the price of an options contract is to a 1% change in implied volatility.

  • What is a Good Vega for Options?

    What a good vega for an options contract is will depend on a variety of factors, chiefly whether or not the contract is long or short.

  • Is Vega the Same for Call and Put?

    Yes - Vega is the same for both calls and put options.

  • Is Vega the Same as Implied Volatility?

    No - although Vega is based on implied volatility. Vega measures how an options contract’s price will change if implied volatility changes by 1% in the underlying asset.

  • Is Higher or Lower Vega Better?

    Higher vega is better for long positions, lower vega is better for shorter positions.

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