Option Greek Vega and Implied Volatility for beginners

There are four Options Greeks- Delta, Vega, Theta and Rho. Out of these four, I have already mentioned that rho is one which most of the investors can ignore most of the time. However the story of Vega is a bit different.

The Options Greek Vega is one of the most important but most ignored one. The concept of Vega is intimately tied to the concept of Implied volatility. This article is a bit long, but If you trade Options or plan to try your hands at Options strategies, read this entire article carefully to see how Options Greek Vega can impact your investments.

Definition: Vega is defined to be the change in the price of an option caused by 1% change in volatility.

There is a slight chance of confusion here, mainly because there are two notions of volatility.

Historic Volatility - This measures how much the underlying stock or index is likely to move in one year. The value of Historic Volatility is calculated using historic values of the underlying, hence the name. Example of Historic Volatility: If a stock has annualized volatility of 40%, then it means that based on the previous price movements of the stock, it seems likely that the stock price will move 40% (up or down) in a period of one year. Historic Volatility is used to calculate the theoretical price of a given Call or Put Option.

Implied Volatility - This is the market perception on how much the stock price is likely to move in a period of one year. How is this 'perception' or implied volatility calculated? The idea is simple. If the market expects a stock price to 'vary' a lot, the call and put options will become more 'expensive'. The exact value of implied volatility is calculated using the market price of Options. Remember that the theoretical value of Options Premium maybe different from the actual price of the Options begin traded in the stock exchange. The reason for this is precisely that theoretical value of Options is based on Historical Volatility. Market price of Options is based on Implied Volatility. An example would be: if quarterly results of a company are about to be declared, then investors may expect sharp movements in the stock price. As a result, for that period of time, the implied volatility of Options on that Stock may be significantly more than the historical value of volatility.

Market Perceptions about a stock or index can change depending upon changing economic conditions. These changes can also be quite sudden, usually due to announcements of new financial data or economic news. Hence the values of Implied Volatility are also vulnerable to sudden changes. How much will change in the (implied) volatility affect the price of the Option? Well, this is exactly the business of Options Greek Vega.

Important characteristic of Options Greek Vega

Vega is always positive for Call and Put Options. The reason for this is that increase in volatility leads to more uncertainty or risk for the writer of Call and Put Options. Hence the Options tend to become more expensive. In other words Vega is always positive.
The values of Vega are same for the Call and Put option with same strike price. In other words for a given strike price, both the call and put option prices will be affected in the same way by changes in Implied Volatility.
Values of Vega are largest for at the money options. As the strike price of the options gets farther away from the current price of the underlying, the option price is less influenced by changes in implied volatility. Thus deep in the money options and deep out of the money options have low values of Vega.
As the time remaining for expiry date of the Option decreases, the value of Vega decreases.

Caution: Vega can be used to calculate expected changes in the Options Price for small variations of the price of the underlying. For example, suppose a call option on a stock costs $5 and the implied volatility is 35%. Suppose the Vega of this particular Call Option is 0.45. In this case if the implied volatility of this stock increases from 35% to 37%, then you can roughly expect an increase of 2 x $0.45 = $0.90 in the price of the option. However if suppose in some situation, the implied volatility increases by a large amount, say 35% to 55%. Then the calculation of the expected change = 20 x $0.45 = $9 is a little less accurate. The reason for this is that the value of Vega itself changes as the implied volatility changes, thus for large variations the calculation is only approximate at best. However most the times, the variations are small and hence price change predictions from Vega Calculations are fairly accurate.

Top two Reasons why Options Greek Vega and implied volatility Cannot be ignored

Let me re-remind you by saying that Options Greek Vega is perhaps the most important and most ignored among the Options Greeks. However, understanding Vega can lead to better Options Trading Strategies and help you decide a better entry and exit point for taking positions in Options. Here are the top reasons why Vega is important or significant.

Values of Vega are usually large. Which means the price of the Option is significantly influenced even by small changes in values of implied volatility. This is one reason why Options Greek Vega cannot be ignored.
Implied Volatility and Covered Options Strategies : Values of implied volatility help you decide if an Option is cheap or expensive. For example, if the historic volatility of an underlying is say 30% and the implied volatility is at 40%, this means that Options are expensive. When values of implied volatility are high, it is worth finding out if there is a significant reason, for example quarter results announcement, or announcement of some financial news etc. There are situations when the volatility is higher but there is a 'preferred' direction for the price to move. For example, if is sudden enthusiasm in the market due to some positive financial news. In this case the Call Option will be a bit more expensive than usual, and writing a covered call is perhaps on of the best Options Strategies in such circumstances. In situations where Implied Volatility is higher but there is is no 'preferred direction' so to speak, writing covered Options is not a good idea.

How to Calculate Options Greek Vega?

The formula to calculate Options Greek Vega is a bit complicated. However the following Excel Spreadsheet Calculator can help you calculate the values of Vega and other Options Greeks (Theta, Delta, Rho) for European style Options using Black Scholes Options Pricing Model.

Download Options Greek Calculator Excel Spreadsheet or Preview
(can be used to calculate Options Greeks Vega and also Options Premium, Option Greeks Theta, Delta and Rho).

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