Vega definition

What is vega in options trading?

Vega in options trading measures how sensitive an option’s price is to changes in the implied volatility of an underlying market. It represents the extent to which an option’s premium will change given a 1% change in an asset’s implied volatility.

Vega and implied volatility

Implied volatility measures the market’s view on the likelihood of movement in an underlying asset’s price. Vega attempts to measure the effect that changes in the volatility of an underlying market will have on an option’s premium, using a one-point change in the implied volatility of an asset as a benchmark.

Vega is always highest when an option is at the money because a sharp spike or decline in volatility can be the difference between whether that option has value, or whether it expires worthless.

Vega tends to decline as an option comes increasingly in the money or out of the money, because changes in volatility will have less of an effect on the value of the option relative to the premium.

Vega example

As an example, let’s suppose that stock XYZ is trading at £45 in May. A June 50 call option on the same stock is selling for £5, which is the premium. A June 50 call simply means that the option is a call option, with a £50 strike price that expires in June.

For the purpose of this example, let’s assume that the implied volatility is 14%, and the vega of the option is 0.15. If the implied volatility increased to 15%, then the price of the June 50 call option would increase to £5.15 (£5 + 0.15).

If the implied volatility had instead decreased to 13%, then the price of the option would decline to £4.85 (£5 – 0.15).

What is vega neutral?

Vega neutral is a method for limiting risk in an options trade by hedging against the implied volatility in an underlying market. A vega neutral strategy will involve taking long and short positions on multiple options, with the aim to create an option portfolio with an overall vega of zero – meaning that the total value of the portfolio will not be affected by changes in implied volatility.