Options Vega Explained
Option contract prices will increase as the probabilities of them expiring in-the-money are greater and will go down as the probabilities of them expiring in-the-money decreases. As options get closer to being in-the-money they capture more of their underlying assets move, as they get farther away from being in-the-money they capture less of their underlying assets move. High volatility increases the odds of an option having the ability to be in-the-money on expiration. Extreme volatility also increases the risk of loss to the option seller with a strong adverse move and an option price will increase to account for the higher risk and compensate the option seller for this risk.
Vega measures an option’s sensitivity when there are changes in volatility of the underlying asset.
Option vega is the measure of the amount of money per underlying share that an option contract value will gain or lose as price volatility rises or drops by 1 percentage point. Both call options and put options will increase in contract value when price volatility rises.
Vega can be one of the most important Greeks to understand and track for an option trader. During more volatile markets and charts the value of option strategies will be very price sensitive to changes in volatility, especially with extreme price range expansion. The cost of at-the-money options, and especially straddle and strangle option plays will become more expensive with changes in volatility on the underliers.
The volatility of an asset is measured by the magnitude and speed that price moves up or down, and can be based on any changes in the recent price range or historical prices in a stock or commodity future contract. Vega will change as there are large price changes in a stock or commodity an option is written on. Vega value in the price of an option will decrease as the option gets close to it’s expiration date or it gets past a risk event like earnings or any other important announcement that could cause a big price move. Vega is the component in pricing of options to account for the risk that a seller is taking on based on the current and estimated volatility of the underlying stock. Options increase in value during times of greater volatility and decrease in times of less volatility and after risk events have passed.
If you purchase a stock that is on a company that will announce its earnings before the options expire the expected volatility and the move of the price that is expected due to that event will be priced into the option. An at-the-money option will give you an idea of the expected move of a stock. If a stock is at 100 and an at-the-money 100 strike call option is normally 3 one week until expiration but earnings are before expiration and the 100 strike is 13 instead of the normal 3 then the odds are that the 3 is the normal theta value and the extra 10 is the vega value pricing in a 10 move after earnings. One thing that trips up new option traders is that that 10 Vega value will be almost completely gone when the option opens for trading the following morning after earnings are announced and digested on the chart.
The stock could open at $110 and your option still be worth $13 as your Vega value has been replaced by intrinsic value and you could still have $3 in theta value. To trade options through earnings you have to overcome the price of the volatility that will be gone after the event with enough intrinsic value of the option going in-the-money to be profitable. Some vega can also be priced into options before major events like Fed minutes, a congressional bill, a crop report, or a big jobs report. Always be aware that options are pricing in moves in time and volatility to compensate the option sellers for their risk taking. Option pricing is very efficient for the known volatility of events. It is the following of trends, systems, reactive technical analysis, and risk/reward ratios that can provide an edge.
Vega tends to expand and retract over time. Markets go from volatile to trending or range bound and back to volatile over time and vega tracks the risk in volatility by pricing it into options contracts. Peak vega pricing is with the at-the-money option in a chain and decreases as options get farther in-the-money or farther out-of-the-money as the probabilities change for the option expiring in the money due to volatility.