Vega With Options Trading Explained (Simple Guide)
If you’d like to know how a change in implied volatility will affect the price of an options contract, you’ll have to look at vega.
Vega is one of “the Greeks.” Those are measurements that give traders insight into how an option will respond to various market forces.
In this guide, I’ll explain vega in detail so you’ll know how to use it when you trade options.
What Is Vega?
Vega tells you how much an option price will change for every 1% change in implied volatility.
If you aren’t familiar with implied volatility (or IV), it’s a measurement that represents the predicted volatility of a stock during the life of an options contract.
A stock with low IV isn’t expected to move much. A stock with high IV is expected to fluctuate wildly.
Keep in mind: implied volatility doesn’t measure the direction of the change of a stock price. It could go up or down.
Implied volatility is expressed as a percentage. A stock with an IV of 15% stands a good chance of landing within 15% of its current price within one year from now.
In this case, “a good chance” means about a 68% chance. It’s a single standard deviation.
So a stock trading at $100 with an IV of 15% stands a 68% of trading somewhere between $85 ($100 – $15) or $115 ($100 + $15) in a year.
Implied volatility affects the price of options contracts. As a rule of thumb, option prices increase and decrease with IV.
If you’re wondering how much a change in implied volatility affects the price of an options contract, you can answer that question by looking at vega.
A Number, Not a Percentage
Although implied volatility is measured as a percentage, that’s not the case with vega. It’s measured as a raw number.
In fact, it’s measured in dollar terms. A vega of 0.15 really means 15 cents.
If you see an option with a vega of 0.15, that means the option price will move 15 cents every time IV changes by a single percent.
Right now, Facebook is trading at $125 per share. Next month’s $126 call option is offered at $6.75. The implied volatility is 48% and vega is 0.15.
Let’s assume that Facebook gets some bad press and the IV jumps to 50%. That’s a 2% increase in implied volatility (50% – 48% = 2%).
How much will that affect the price of the options contract? You can answer that question with some simple math.
Since the vega measures the change in contract price for every 1% move in IV, and Facebook’s IV moved by 2%, the price of the options contract should increase by 30 cents (0.15 x 2) to $7.05.
If the IV popped by three percentage points, then you would expect the price of the contract to increase by 45 cents (0.15 x 3) to $7.20.
On the other hand, if implied volatility drops by three percentage points, the price of the contract should drop by 45 cents to $6.30. It works both ways.
Read Also: Calendar Options Strategy Explained
How Time Affects Vega
Typically, the more time until options contract expiration, the higher the vega.
Why? Because of time value.
When an options contract doesn’t expire for a while, that gives the underlying stock more time fluctuate. As a result, time decay hasn’t eroded its value as much as the value of options that are close to expiration.
When you’re evaluating long-term options (called LEAPs), keep in mind that the vega you’re looking at today could be quite different from the vega three months from now.
Read Also: Options Vs Stocks?
Ignore Vega and Lose Money Even When You’re Right
It’s important to pay attention to vega because you could lose money even if you make an options trade that correctly predicts the direction of the underlying security.
Let’s say the stock market just tanked and you’d like to trade a SPDR ETF call option to make money off of the rebound.
The ETF is currently trading at $234.34. You think it could easily spike to $238 in the coming days so you check out the price of next month’s $238 call option.
That option is offered $6.51. That means it would cost you $651 to purchase it because options are traded in blocks of 100 shares ($6.51 x 100).
Since you’re so sure that the market is going to reverse, you don’t bother checking any of the Greeks. You buy the call option and wait.
Your prediction was accurate. The market stemmed its losses and reversed. The SPDR ETF is now up to $238 per share.
However, the call option that you bought for $6.51 is worth only $4.00. You lost money!
How is that possible even though you made the right call?
It’s possible because you ignored vega. Reversal rallies often coincide with a decline in implied volatility. When IV drops, you can expect the value of your option to drop right along with it.
If you had consulted the Greeks, you would have seen that the vega for the call option 0.27. That means a drop in implied volatility of just 4% will take more than a dollar off the price of the option (.27 x 4 = $1.08).
Add to that the natural time decay of options and you could easily lose money even when you make the right call about the ETF.
So what should you have done in that case?
If you anticipate a decline in IV, there are ways to profit off of that while also making money off of the rebound in the market.
For example, you could have shorted a put option.
At the time you bought the call option, next month’s $235 put option was trading for $8.99. Let’s say you had sold that instead of buying the call option.
You would have made money.
When the IV shrinks on put options, it erodes their value the same as it does with call options. That means you make money because you’re short the put option.
Even better, the value of the option itself decreases as the value of the underlying ETF increases. That’s because it’s a put option and not a call option.
Again: you’re short so you earn a positive return when the put option drops in value.
So you make money by shorting the put option for two reasons:
- Implied volatility dropped
- You made the right call about the direction of the SPDR ETF
Keep in mind: shorting a put option is extremely risky because your losses could be enormous if the underlying security goes into free-fall. If you think that selling a put option is the right way to go, consider hedging yourself by purchasing a put option at a lower strike price. That will limit your loss if your prediction was wrong.