Vega is the Rodney Dangerfield of the Greeks -- it just doesn't get the respect it deserves. It is the Greek that follows implied volatility (IV) swings. Vega is defined as the amount a theoretical option's price will change for a corresponding one-unit (point) change in the implied volatility of the option contract.
Vega does not have any affect on the intrinsic value of options; it only affects the extrinsic value or often referred to as the time value of the options price.
It is important to also note that it references implied and not historical volatility. Implied volatility is calculated from the current price of the option, while historical volatility is calculated from the actual price movements of the underlying security.
For a review of implied and historical volatility definitions and the differences of each please see my earlier post titled: Why do we care about Volatility.
Let's consider an example: a 100 strike call option, with the stock trading at 100, 30 days to expiration, and implied volatility of 20%. The price of the option is $2.50 and the Vega would be equal to .115 or 11 ½ cents. This means if nothing else in the marketplace changes except the implied volatility on the option increases one percentage point to 21%, this contract will theoretically increase by the amount of Vega, which implies it should trade for around 2.50 + .115 or $2.615 in absolute terms.
A few rules-of-thumb on Vega: Vega is typically larger for options with more extrinsic value. Which means it will usually be larger for ATM options vs In- or Out-of-the-money contracts. Also, the further out you go in time, the larger the percentage of the option price will be extrinsic value or time premium, so longer dated options will usually have larger Vegas then the near-term contracts.
Vega is also usually higher for option contracts that trade with higher implied volatilies - since this high level of volatility typically makes the option contract more costly. Another thing that will drive up the cost is the value of the underlying. If the underling is expensive the options will be also. Since the extrinsic value of these options is typically high, accordingly Vega will be a larger number.
Bottom line is options that have some or all of these characteristics are typically more susceptible to fluctuations in implied volatility.
To summarize, here's a cheat-sheet of conditions that usually translate to higher Vega values:
Next post will show some real examples and discuss how Vega can be calculated for an entire position.
Regards,
Brian (OG)
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While Vega represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (point) change the implied volatility the option contract there is no guarantee that this forecast will be correct.
