Vega is an option greek that measures how much an option's price is expected to change for a 1% change in implied volatility, assuming all other factors remain unchanged.
Vega helps traders understand how sensitive an option is to changes in market expectations of future volatility. Options with higher vega are more affected by changes in implied volatility.
Vega can be compared to the price of insurance. When uncertainty increases, insurance becomes more expensive. Similarly, when expected market volatility increases, option premiums often become more expensive.
Example
A call option has:
- Premium = ₹100
- Vega = 5
If implied volatility rises from 15% to 16%:
- Option premium is expected to increase by approximately ₹5.
- New premium ≈ ₹105.
If implied volatility falls from 15% to 14%:
- Option premium is expected to decrease by approximately ₹5.
- New premium ≈ ₹95.
Why is vega important?
Vega helps traders:
- Estimate the impact of volatility changes on option premiums.
- Compare options with different volatility sensitivity.
- Manage positions around major events such as earnings announcements or policy decisions.
- Understand why option premiums can change even when the underlying asset remains unchanged.
- Evaluate volatility-based trading strategies.
For both option buyers and sellers, vega helps quantify exposure to changes in market expectations.
What are the limitations of vega?
Some limitations include:
- Vega measures sensitivity to implied volatility, not realised volatility.
- Implied volatility can change unpredictably.
- Vega is generally highest for ATM options and longer-dated contracts.
- Changes in other factors can offset the impact of volatility changes.
- Vega itself changes as the underlying price and time to expiry change.
For these reasons, traders often use vega together with delta, gamma, and theta when managing option positions.