Because implied volatility is used to determine the price of an options contract, the higher the implied volatility of the underlying security, the higher the options contract price will be. Thus, if an investor expects volatile markets, vega can be a valuable tool to find out how much the option premium will change as the implied volatility of a security swings up or down. For example, perhaps you want to invest in call options on ABC Technology Inc. You are trying to decide between two call options:
Call Option #1: The option premium is $5. The expected volatility is 40%, with a vega of 0.10. Call Option #2: The option premium is $5.50. The expected volatility is 40%, with a vega of 0.15.
In this example, the vega is positive, which indicates that if the expected volatility increases, so does the price. Thus, for every 1% increase in expected volatility, the option’s price will increase by the same amount as the current vega—which would be a 10-cent price increase for the first option and a 15-cent rise for the second option. Let’s say the volatility of both options increases from 40% to 41%. This means that each option’s price would change accordingly:
Call Option #1: The vega is 0.10, so the price would increase from $5 to $5.10.Call Option #1: The vega is 0.15, so the price would increase from $5.50 to $5.65.
You prefer to pick the option whose price is expected to be less volatile, so in this example, you choose to purchase the Call Option 1 contract with a lower vega.
Alternatives to Vega
There are four other mathematical calculations aside from vega that investors also refer to when talking about the Greeks. They are all used to calculate the risk involved in purchasing different options contracts. The four Greek calculations that are alternatives to vega are:
Delta: Delta measures the sensitivity of an options price to the changes in the value of the underlying security. As the price of a stock increases or decreases, delta measures how this affects the options contract price on that stock. Theta: Theta measures the rate of time decay of an option. In other words, it tells you how the value of an option decreases as it nears its expiration date. Gamma: Gamma is a derivative of delta, and it measures the rate of change in delta against the change in the price of a security. If the value of a security increases or decreases by $1, gamma will illustrate how much this affects the option price. Rho: Rho measures how current interest rates affect the price of an options contract. It tells investors the rate of change in value for every 1% change in interest rates.
Vega vs. Implied Volatility
Implied volatility, also known as IV, is part of a formula used for pricing options contracts, while vega is a Greek mathematical calculation used to measure how IV affects the price of an option. If a stock is deemed to be volatile, you can expect that any options contracts on it will likely be even more volatile than the underlying stock price. Vega is the way to measure and compare this volatility among different options contracts.
