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The vega indicates the extent to which the option price changes if the volatility of the underlying price changes by one percentage point. It is assumed that all other factors influencing the option price remain the same.
If the volatility falls because there are significantly fewer price changes in the underlying asset, the option price also falls. Conversely, if the volatility of an underlying asset increases, the option price increases. The respective vega shows the absolute change in the price of the option premium if the volatility changes by one percentage point.
Strangely enough, the term vega has become “naturalized” as one of the option greeks. Vega is not a Greek letter at all. This is why lamda or kappa is sometimes used in the literature. But how can it be used advantageously?
The Vega of an option in the example
Assume that the volatility of a share is 40% and the option price for a share is 2 euros. It should be a long position. The corresponding vega is 0.05.
If the volatility increases by 1% to 41%, the option price increases by the vega from 0.05 to 2.05 euros. For a standard contract size of over 100 shares, this means that the option price increases from EUR 200 to EUR 205. If, on the other hand, volatility falls by 1%, the option price will also fall to Euro 1.95 per share. For 100 shares, this results in a value of 195 euros for an option, which is 5 euros lower.
It is important to know that the vega is always positive for long positions. Option holders therefore always benefit when volatility increases. For short positions the vega is negative. Holders of a put therefore profit from falling volatility.
If you compare two options with the same underlying asset and the same strike but different terms, you can see that the vega of the option with longer terms is always higher. The reason is quite simple. The shorter the maturity, the less susceptible the option price is to changes in volatility. Therefore, one has to consider a completely different option gage.
How is the Vega of options calculated and applied?
The Vega is calculated using the Black-Scholes formula based on a risk-free interest rate in the market, the term of the option, the agreed strike, the volatility and the current price. However, investors do not have to calculate the Vega themselves. After all, the formula is quite complicated. In the trading lists of the options brokers, all option greens are constantly recalculated and displayed. Options traders simply need to read the value of an option.
The Vega of options is a very useful indicator, along with the Delta. It can be used in practice to estimate approximately how the option price will change if the volatility in the market for a stock or other underlying asset underlying an option changes.
This is roughly because when calculating the vega, it is assumed that all other factors influencing the option price remain constant, which will never be the case in practice.
With long positions, i.e. call options, the vega is always positive. For short positions, it is always negative. In principle, the longer the term of an option in relation to one and the same underlying asset, the higher the vega.
Read my other articles about options:
- Bear Call Spread Options Strategy
- Bull Put Spread – Earn Money With Puts And Limit Risk
- Butterfly Spread Options Strategy
- Definition Of Option Price/Option Premium
- Earn Money With A Covered Call Options Strategy
- How to exercise Options
- How to use the Standard Deviation for Options Trading
- Iron Condor – Profit From Low Price Fluctuations
- Options Trading Tutorial for beginners
- Options vs. Futures – Two Different Types Of Futures Contracts
- Options vs. Warrants – 4 Differences
- Protective Put – Hedging Of Equity Positions
- Simple Trading Strategies for Options
- Term structure options
- What are options? – Explained Simply And Quickly
- What is a Long Call in Options Trading?
- What is a Long Put in Options Trading?
- What is a Short Call in options Trading?
- What is a Short Put in Options Trading?
- What is delta in Options Trading? – The Most Important Key Figure
- What is Historical Volatility in Options Trading?
- What is the Gamma in Options Trading?
- What is the Implied Volatility Of Options – Important Or Not?
- What is the Theta in Options Trading?
- What Is The Vega Of An Option?