Last definition over the series! We are back on the Greeks! Yesterday you learned about implied volatility and why you need to understand the concept for buying and selling contracts. Today’s topic is another topic that is directly related to implied volatility: Vega.
What is Vega?
Vega is simply the value an option price will change with a 1% move in implied volatility. Like with other greeks, it doesn’t have any effect on the intrinsic value of options but is an indicator of potential future value. It is only a measure of the potential fluctuation in contract value with a change in volatility.
In general, the more time remaining until contract expiration, the higher the vega. When you are far away from a contract's expiration, a greater proportion of the option’s premium is accounted for by time value, and the time value is sensitive to changes in volatility. Remember that a portion of a contract's premium is made up of time value, and this proportion changes as you approach the expiration date.
Let’s examine a 30-day option on SQ stock like we did yesterday with a $50 strike price and the stock trading exactly at $50. Vega for this option could be .05. In other words, the value of the option might go up $.05 if implied volatility increases one point, and the value of the option might go down $.05 if implied volatility decreases one point.
If you looked at the 365-day at-the-money SQ option, Vega could be as high $.30 meaning the value of the contract could fluctuate by as much as $.30 when implied volatility drops by a point.
Why It Matters
As IV increases, the value of the options contract will increase as well. This is because the anticipated volatility would cause the stock to potentially increase in even more value, causing the value of its options to appreciate. When volatility drops, we subtract vega due to the drop in IV.
Vega and implied volatility are more predictable than a stock’s direction because it is so correlated with time. Since Vega is related to implied volatility, it is a measure of the market's expectation of a change of volatility in the time period of the contract. If you’re feeling confused, don’t worry: We’ve got more educational material to help you out!
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