What is 'Vega'
Vega is the measurement of an option's sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an option contract's price changes in reaction to a 1% change in the implied volatility of the underlying asset. Volatility measures the amount and speed at which price moves up and down, and is often based on changes in recent, historical prices in a trading instrument.
BREAKING DOWN 'Vega'Vega changes when there are large price movements (increased volatility) in the underlying asset, and falls as the option approaches expiration. Vega is one of a group of Greeks used in options analysis and is the only lower order Greek that is not represented by a Greek letter.
Differences Between Greeks
One of the primary analysis techniques utilized in options trading is the Greeks – measurements of the risk involved in an options contract as it relates to certain underlying variables. Vega measures the sensitivity to the underlying instrument's volatility. Delta measures an option's sensitivity to the underlying instrument's price. Gamma measures the sensitivity of an option's delta in response to price changes in the underlying instrument. Theta measures the time decay of the option. Rho measures an option's sensitivity to a change in interest rates.
As stated previously, vega measures the theoretical price change for each percentage point move in implied volatility. Implied volatility is calculated using an options pricing model and determines what the current market prices are estimating an underlying asset's future volatility to be. However, the implied volatility may deviate from the realized future volatility.
The vega could be used to determine whether an option is cheap or expensive. If the vega of an option is greater than the bid-ask spread, then the options are said to offer a competitive spread, and the opposite is true. For example, assume hypothetical stock ABC is trading at $50 per share in January and a February $52.50 call option has a bid price of $1.50 and an ask price of $1.55. Assume that the vega of the option is 0.25 and the implied volatility is 30%. Therefore, the call options are offering a competitive market. If the implied volatility increases to 31%, then the option's bid price and ask price should increase to $1.75 and $1.80, respectively. If the implied volatility decreased by 5%, then the bid price and ask price should theoretically drop to 25 cents and 30 cents, respectively.