Vega is a measurement used to understand the price sensitivity of an options contract as the expected volatility of the underlying security changes. It’s among the many mathematical calculations that investors often refer to as “the Greeks,” which are calculations used for assessing the overall risk of an investment.
How does vega work, and when should an investor use it? Find out what you need to know about vega for investing in options.
Definition and Examples of Vega
Vega measures how sensitive the premium of an options contract is when the implied volatility (IV) of the underlying security changes by 1%. In other words, for every 1% change in the implied volatility, how much does that affect the option’s market price? Vega tells us the answer to this question. It’s a mathematical calculation that helps options traders align their risk tolerance with the expected risk of an options contract.
Because implied volatility is used to determine the price of an options contract, the higher the implied volatility of the underlying security, the higher the options contract price will be.
Thus, if an investor expects volatile markets, vega can be a valuable tool to find out how much the option premium will change as the implied volatility of a security swings up or down.
For example, perhaps you want to invest in call options on ABC Technology Inc. You are trying to decide between two call options:
- Call Option #1: The option premium is $5. The expected volatility is 40%, with a vega of 0.10.
- Call Option #2: The option premium is $5.50. The expected volatility is 40%, with a vega of 0.15.
In this example, the vega is positive, which indicates that if the expected volatility increases, so does the price. Thus, for every 1% increase in expected volatility, the option's price will increase by the same amount as the current vega—which would be a 10-cent price increase for the first option and a 15-cent rise for the second option.
Let's say the volatility of both options increases from 40% to 41%. This means that each option's price would change accordingly:
- Call Option #1: The vega is 0.10, so the price would increase from $5 to $5.10.
- Call Option #1: The vega is 0.15, so the price would increase from $5.50 to $5.65.
You prefer to pick the option whose price is expected to be less volatile, so in this example, you choose to purchase the Call Option 1 contract with a lower vega.
Vega is especially helpful to investors when purchasing options during volatile market conditions.
Alternatives to Vega
There are four other mathematical calculations aside from vega that investors also refer to when talking about the Greeks. They are all used to calculate the risk involved in purchasing different options contracts. The four Greek calculations that are alternatives to vega are:
- Delta: Delta measures the sensitivity of an options price to the changes in the value of the underlying security. As the price of a stock increases or decreases, delta measures how this affects the options contract price on that stock.
- Theta: Theta measures the rate of time decay of an option. In other words, it tells you how the value of an option decreases as it nears its expiration date.
- Gamma: Gamma is a derivative of delta, and it measures the rate of change in delta against the change in the price of a security. If the value of a security increases or decreases by $1, gamma will illustrate how much this affects the option price.
- Rho: Rho measures how current interest rates affect the price of an options contract. It tells investors the rate of change in value for every 1% change in interest rates.
Vega does not predict the future price movements of a security or an options contract (nor do any of the Greeks). It is a mathematical calculation to give the best estimate of the future movement of an options price as the implied volatility fluctuates.
Vega vs. Implied Volatility
Implied volatility, also known as IV, is part of a formula used for pricing options contracts, while vega is a Greek mathematical calculation used to measure how IV affects the price of an option.
|Vega||Implied Volatility (IV)|
|Vega measures the price sensitivity of an option as implied volatility changes||IV measures the expected future volatility of a security|
|It is a derivative of implied volatility||Derived from options contract prices for a security|
|Tells you how much the value of an option should move up or down, based on a 1% change in IV||It is a piece of one of the formulas used for pricing an options contract|
What It Means for Individual Investors
Investors who choose to purchase options contracts will benefit greatly by understanding how to use vega to assess the risk of the investment. When an investor understands how vega works, they also learn that options contract premiums can be expected to be much more volatile if the underlying stock is considered a riskier investment.
If a stock is deemed to be volatile, you can expect that any options contracts on it will likely be even more volatile than the underlying stock price. Vega is the way to measure and compare this volatility among different options contracts.
- Vega is a calculation used to measure how sensitive an options contract’s price is to the measurement of implied volatility. It tells you how much an option’s premium will change per 1% change in the implied volatility of the underlying stock.
- Vega is among the Greek mathematical calculations used to assess risk when trading options contracts.
- Alternatives to vega include four other Greek calculations: delta, theta, gamma, and rho.
- Vega is different from implied volatility (IV) in that it measures the price sensitivity of an options contract, whereas IV measures the expected future volatility of the underlying security.
- Investors can benefit from understanding vega, especially when trading options contracts in a volatile market.