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Option Vega

The option's vega is a measure of the impact of changes in the underlying volatility on the option price. Specifically, the vega of an option expresses the change in the price of the option for every 1% change in underlying volatility.

Options tend to be more expensive when volatility is higher. Thus, whenever volatility goes up, the price of the option goes up and when volatility drops, the price of the option will also fall. Therefore, when calculating the new option price due to volatility changes, we add the vega when volatility goes up but subtract it when the volatility falls.

Example

A stock XYZ is trading at $46 in May and a JUN 50 call is selling for $2. Let's assume that the vega of the option is 0.15 and that the underlying volatility is 25%.

If the underlying volatility increased by 1% to 26%, then the price of the option should rise to $2 + 0.15 = $2.15.

However, if the volatility had gone down by 2% to 23% instead, then the option price should drop to $2 - (2 x 0.15) = $1.70

Passage of time and its effects on the vega

The more time remaining to option expiration, the higher the vega. This makes sense as time value makes up a larger proportion of the premium for longer term options and it is the time value that is sensitive to changes in volatility.

Time to Expiration and its Effects on Option Vega

The chart above depicts the behaviour of the vega of options at various strikes expiring in 3 months, 6 months and 9 months when the stock is currently trading at $50.

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