Options Greeks: Vega Risk and Reward

Vega measures the rate of change in the implied volatility of an option or position, which is similar to the way that Delta measures the change in an underlying asset price. Implied volatility is the expected volatility of the underlying asset over the life of the option – not the current or historical volatility of the asset. In particular, Vega shows traders how much an option price will change for each 1% move in implied volatility.

For example, the table below shows AAPL options that expire in three months assuming a $157.44 current price. The in-the-money call option with a $139.00 strike price has a Vega of 0.085, which means that the option’s price will increase about $0.09 for each 1% increase in implied volatility. Similarly, the out-of-the-money call option with a $160.00 strike price has a Vega of 0.212, which means that it will increase about $0.21 for each 1% increase in IV.

It’s important to remember that implied volatility reflects price action in the options market. When option prices are bid up, implied volatility will increase, and vice versa when option prices move lower. Long option traders benefit from pricing being bid up and short option traders benefit from prices being bid down. This is why long options have a positive Vega and short options have a negative Vega.

How Vega Impacts Strategies

Vega values are positive for buying options and negative for selling options. For example, credit spreads or naked options have negative values and debit spreads or call options have positive values. At-the-money options with the most days until expiration tend to have the highest Vega values since they benefit the most from an increase in volatility, while the opposite is true for out-of-the-money options with few days until expiration.

The table below shows position Vega for common options strategies:

Vega can be a source of confusion for novice traders. For example, suppose that a novice trader believes that the market has reached a bottom and purchase a call or bull call spread. Assuming that Theta is not a factor, the long call position would result in a gain thanks the position’s positive Delta, which suggests that the option price will increase along with the underlying asset price (that would presumably increase if a market is bottoming out).

The problem is that the Vega hasn’t been factored into the equation. Rebound reversal rallies tend to generate large implied volatility declines, which means that the Vega losses could more than offset the Delta gains. The trader may have correctly predicted the direction of the rebound, but the decline in volatility would have wiped out those gains. A better option would have been a short put or in-the-money bull call spread that is long Delta and short Vega.

The Bottom Line

Vega is a measure of an option’s price change when an underlying asset’s implied volatility changes. Option traders should have a good understanding of how Vega impacts an option’s price to differentiate between strategies that may appear the same on when looking only at how Delta would impact the price. This can save you a lot of pain over the long-run as you evaluate different strategies and pick those that work best.