What is Vega
Vega is the measurement of an option's price 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 can be based on recent changes in price, historical price changes, and expected price moves 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.
Differences Between Greeks
One of the primary analysis techniques utilized in options trading is the Greeks. The Greeks measure how option prices react to different 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 time decay of the option. Rho measures an option's sensitivity to a change in interest rates.
Vega measures the theoretical price change for each percentage point move in implied volatility. Implied volatility is calculated using an option pricing model that determines what the current market prices are estimating an underlying asset's future volatility to be. Since implied volatility is a projection, it may deviate from actual future volatility.
If the vega of an option is greater than the bid-ask spread, then the option is said to offer a competitive spread. The opposite is also true.
Vega also lets us know how much the price of the option could swing based on changes in the underlying asset's volatility.
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%. The call options are offering a competitive spread: the spread is smaller than the vega. That does not mean the option is a good trade, or that it will make the option buyer money. This is just one consideration, as too high of a spread could make getting into and out of trades more difficult or costly.
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 (1 x $0.25 added to bid-ask spread). If the implied volatility decreased by 5%, then the bid price and ask price should theoretically drop to $0.25 by $0.30 (5 x $0.25 = $1.25, which is subtracted from $1.50 and $1.55). Increased volatility makes option prices move expensive, while decreasing volatility makes options drop in price.
Just as price moves are not always uniform, neither is vega. Vega changes over time. Therefore, the traders who use it monitor it regularly. As mentioned, options approaching expiration tend to have lower vegas compared to similar options that are further away from expiration.