What is Vega in options trading?

The Vega of an option measures the amount of change in an option contract's premium as a result of a 1% change in its Implied Volatility.

Implied Volatility (IV) represent the likelihood of a change in the underlying's price.

  • Vega indicates changes in expectations for future volatility and is positive.
  • Higher volatility makes options more expensive since it is more likely to reach the strike price.
  • IV increases with uncertainty in the market; the higher the volatility, the higher the price of the options contract.
  • The longer an options contract has until expiry, the more volatility will affect its price- Vega falls as a contract approaches expiry and increases as the underlying moves closer to the strike price.
  • An increase in vega generally causes options (both call and put) to gain value. 
  • A decrease in vega generally causes options (both call and put) to lose value.

For example, NIFTY spot is at 17,400 on 15th Dec. On 30th Jan, NIFTY call options are selling for Rs.120. Let's take vega to be 20 and IV to be 12% (0.12).
If the IV increases to 13%, the price of the option will rise to Rs. 140 (120 + 20).
Similarly, if the IV decreases to 10%, the price of the option will fall to Rs. 80 (120 - (2 * 20))

  • At the money contracts have higher vega since sharp changes in volatility determine whether the option has value or it will expire worthless.
  • As a contract becomes increasingly in the money or out of the money, vega tends to decline as changes in volatility don't have much of an effect on the value of an option (in comparison to its premium).

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