Compared to a stock or bond, options are contracts with a shelf-life and are exposed to a range of unique risks – greeks (i.e. delta, gamma, theta, vega, rho) - each of which measures the sensitivity to some variable including time and movement.

However, all derivative traders know that option prices actually boil down to the market’s expectancy of future volatility of the underlying asset, since all the other determinants of an option’s price—the underlying price, time to maturity, interest rate, and strike price—are objective. Volatility is the subjective X factor, and seldom does an option’s actual, realized volatility replicate the implied volatility reflected in its valuation.

Continue Reading Below

**Definition of Vega**

Vega—the single options greek that isn’t characterized by a real greek letter—is an estimate of how much the theoretical value of an option changes when implied volatility changes 1 percent. Higher implied volatility implies higher options prices. Why? Higher implied volatility typically results in a greater price swing (variance) in the underlying asset price, which translates into a greater possibility for an option to be profitable by expiration.

Lower volatility implies lower options prices, for the opposite reason: Lower implied volatility signposts a smaller swing (variance) in the underlying asset price, translating into less likelihood that the option will be profitable by its expiration date.

Long calls and long puts always have positive vega. Short calls and short puts always have negative vega. Stocks and futures have zero vega—their values are not affected by volatility. Positive vega means that the value of an option position increases when volatility increases and decreases when volatility heads lower. Simply put, vega is the derivative of the option value with respect to the volatility of the underlying.

For example, SPDR Trust Series (SPY) June ’15 202 call (reference: $201.79) has a current market value of $8.96 and a vega of $0.54 with the current implied volatility at 17 percent. If the implied volatility of June SPY should rise to 18 percent, the value of the SPY June ’15 202 call (assuming all other variables remain constant) would climb $0.54 to $9.50. On the other hand, if June SPY implied volatility should drop from 17 to 16 percent, the new market value of the SPY June ’15 call would be quoted at $8.42.

Advertisement

**Vega and Money-ness**

At-the-money options have more vega as compared to either in-the-money or out-of-the money options. This means that the value of at-the-money options changes the most when volatility changes. Other words, vega is at its maximum point for an at-the-money option – implying approximate positive linearly comparative to its implied volatility. However, the out-of-the and in-the-money option is always the most sensitive in percentage terms, to a change in volatility, as compared with the at-the-money option.

For example, **Powershares QQQ Trust Series** **(QQQ)** (reference price of $103.50). Currently the September ’15 at-the-money strike has a vega of $0.30 compared to a 10% in-the-money strike vega of $0.20 and 20% out-of-the-money strike vega of $0.07. Notice the farther away you are from the at-the-money strike, the less the vega of the option.

**Vega and the Passage of Time**

The vega of an option decreases with the passage of time - i.e. A longer-dated options always has a higher vega than a shorter-dated option. That should make sense as the more time to expiration an underlying asset has, the more uncertainty there will be as to where it will end up by expiration, which translates into greater buyer opportunity and seller risk. This results in a higher vega for options with longer time to expiration in order to compensate for the additional risk assumed by the seller.

For example, **SPDR Trust Series (SPY)** (reference: $201.79. The vega of the January ’15 202 strike is currently $0.20, while the June ’15 202 strike has a vega of $0.54, compared to the December ’15 202 call which has a vega of $0.75.

**Vega and Volatility**

If the volatility of an underlying asset changes, option vega changes as well. Option vega is greatest for options at-the- money, and it is smaller for options completely out -of -the money or very deeply in-the- money. This can be explained more easily by saying that if the option is near worthless, it doesn’t matter how volatile the underlying asset is, because the chance the option will suddenly become in-the-money is relatively small. If the option is deeply in-the-money, the chance that the option will suddenly become worthless with increased volatility is also relatively slim. But if the option is at-the-money, which is on the verge of being worthless or valuable, then even a relatively small change in the volatility in the price of the underlying asset can change the position.

An options trader must understand not only vega, but also the correlation of underlying movement and its effects on implied volatility and vega. Where are your strikes concentrated? If volatilities go up or down significantly, how is your long or short vega going to change? And, by how much? What will occur if you’re short a lot of out-of-the-money strikes and volatility/implied volatility skew suddenly moves up? Originally, you may have been well within your personal risk tolerance level, but when things got a little more nervous, you may find that you’re suddenly short volatility—and all of those out-of-the-money options suddenly have loads of vega. Now you’re short lots of volatility, more than you bargained for, and your broker will want to know why—and what you’re going to do about it.

## What do you think?

Click the button below to comment on this article.