Vega or Option Vega refers to the measure of an option’s sensitivity brought by changes in volatility affecting a particular security. As part of the option Greeks, it expresses the changes in an option price brought about by every 1% shift in volatility.
As you already know, volatility measures the amount and speed of price movement and thus it is based on historical price changes for a particular financial instrument.
Option Vega does change when large price movements occur indicating increased volatility in a particular security occurs. It also falls when the option approaches expiration.
Finding Option Vega
As you already know, Vega is represented by a dollar amount. It comes out of the option pricing model which makes it a product of calculation.
This means that Option Vega has a model risk thus inputs and outputs complement each other. It is important to understand that model risk does not pose any serious threat.
The good thing about the option chain is that it can be customized and can display different Greeks. If you want to view an option chain, you can check with your broker if they allow option trading.
Importance of Options Vega
To understand Vega, you need to understand implied volatility too. As you already know, when a certain company is expected to share important news or earnings, its stock will experience higher implied volatility.
This means that its price will rise as the appointed date for the important news approaches. Apart from the market news, implied volatility occurs due to the uncertainty involved with the news outcome.
It is common in such circumstances for market makers to hike implied volatility. As a result, they will be in a position to charge higher prices because of increased demand.
When the above situation occurs, you will find traders and investors taking neutral delta and gamma positions. This happens days before the announcement of the important news.
Due to this, traders and investors are able to profit from the increased price and close their positions before release. If implied volatility declines fast, a large chunk of value will be deducted from the option as well.
This is referred to as a volatility crush. As a trader or investor, buying stock options when Vega is high could be disastrous especially if you plan to take a long position. Always analyze the market before you enter a trade.
Vega is a useful Greek that helps to forecast how an options price will move and that is why it is important to take time to understand how it works. As an investor or trader, having a clear picture of how implied volatility affects option price will enable you to mitigate risks and locate more trading opportunities.