Introduction To Vega
We will learn the option-greek ‘Vega’ in this section.
Vega measures the change in option price per unit change in Volatility. If the absolute value of Vega is high, the portfolio’s value is very sensitive to small changes in volatility. However, if the absolute value of Vega is low, volatility changes have relatively little impact on the value of the portfolio. A Vega value of 6.87 shows that for every unit increase in volatility, option price will increase by 6.87.
- Vega of an option is always positive.
- Vega of call and put is same.
- Vega is the highest at ATM and decreases as the spot moves away in either direction (bell shaped).
Impact of Vega on a Portfolio of Options:
When you buy Call option, positive Vega multiplies by positive quantity, hence gives positive portfolio Vega which signifies that buying call option means long Vega position.
When you sell Call option, positive Vega multiplies by negative quantity, hence gives negative portfolio Vega which signifies that selling call option means Short Vega position.
When you buy Put option, positive Vega multiplies by positive quantity, hence gives positive portfolio Vega which signifies that buying put option means long Vega position.
When you sell Put option, positive Vega multiplies by negative quantity, hence gives negative portfolio Vega which signifies that selling put option means Short Vega position.
When thinking about Vega, we have to remember that expected volatility (implied volatility) is a reflection of price action in the options market. When options are bought by traders, expected volatility will increase. When options are being sold, expected volatility will decrease. With that said, when being long on options, we want the price of the option to increase. When being short on options, we want the price of the option to decrease.
That is why long options have positive Vega, and short options have negative Vega.
An increase in expected volatility will benefit the long option holder, as that indicates an increase in option pricing, hence the positive Vega assignment. A decrease in expected volatility will benefit the short option holder, as that indicates a decrease in option pricing, hence the negative Vega assignment.
When volatility increases, the stock/index price starts swinging heavily. To put this in perspective, imagine a stock is trading at ₹200; with an increase in volatility, the stock can start moving anywhere between ₹180 and ₹220 very quickly. So when the stock hits ₹180, all PUT option writers will start panicking as the Put options now stand a good chance of expiring In the money (ITM). Similarly, when the stock hits ₹220, all CALL option writers would start panicking as all the Call options now stand a good chance of expiring In the money (ITM).
Therefore irrespective of Calls or Puts when volatility increases, the option premiums have a higher chance to expire in the money.
Next, in our upcoming sections, we will study the effect of different parameters on Vega.
