Collectively, the Greeks are used by options traders to have a clearer idea of how various factors impact on the price of options. Vega is the value that provides a theoretical indication of the rate at which the price of will change in relation to changes in the volatility of the underlying security.
The vega value of an option shows how much, in theory, the price will change for every percentage point the implied volatility of the underlying security increases by. On this page we explain the characteristics of vega and how it can be used by traders.
To fully understand this particular subject, we would strongly recommend that you are first familiar with volatility and implied volatility and how they affect the price of options. If you need further information on this, please read this article.
Characteristics of Vega
The first thing you should be aware of regarding Vega is that it relates only to the extrinsic value of an option, and not the intrinsic value. Whether you are buying calls or puts, the vega value is always positive. However, when you write options the vega value is effectively negative.
Basically, the vega value tells you how much the price of an option should increase by for every percentage point increase in the implied volatility of the underlying security. As an example, if an option had a vega value of .20 then the price would theoretically increase by $.20, and then the implied volatility of the underlying security increases by 1%. It should also fall by $.20 if the implied volatility of the underlying security decreased by 2%.
As with all the Greeks, the effect of Vega is based on all other factors that affect the price of the option being equal.
Vega is affected by two factors: moneyness and the amount of time left until the expiration date. It's typically at its highest when an options contract is at the money, and then reduces if the contract moves into the money or out of the money. As a general rule, the further away the price of the underlying security is from the strike price the lower the vega value of that contract will be. As the extrinsic value of an option tends to be higher the closer it is to the money, and the vega value only affects extrinsic value, it stands to reason that this would be the case.
For similar reasons, the vega value will be higher when there is a long time until expiration and lower when there is less time until expiration. The extrinsic value will reduce as the expiration date of that option approaches, it once again makes sense that the vega value will reduce accordingly. Vega is also closely related to gamma. When the gamma value of an option is high, you can expect the vega value to also be high.
Putting Vega to Use
Traders tend to pay more attention to the delta, theta, and gamma values of options than they do the vega value. However, out of all the Greeks, vega is second only to delta in terms of the level of effect it (theoretically) has on prices. It's probably so widely ignored largely due to the fact that it's slightly more complex to understand, and because it requires a fundamental understanding of volatility and implied volatility: which is far from a simple subject itself.
Also, a large number of traders are far more concerned with how the price movements of the underlying securities affect the price of options than anything else.
Given that vega can be very useful in forecasting how the price of an option is likely to move, it really is worth putting in some time to understanding just what volatility and implied volatility is all about. Once you have a clear idea of how the price of options is affected by implied volatility, and changes in implied volatility, you will be much better positioned to gauge the risks involved in any possible trades you identify, and may even find opportunities based on the volatility of particular underlying securities.
There are certain trading strategies for a volatile market that can be used to profit from changes in volatility, even when the price of the underlying asset remains static. If you wish to use such strategies, such as the long straddle or the short straddle, then a good knowledge of Vega and what it means is essential.