The fundamental of a futures contract is that it can be an efficient and effective trading tool or risk management tool. The core performance of this contract is essentially two-dimensional. The possibilities are that your value or returns are either up or down based on the entry price point. However, with options and futures, they extend to much more than just being two-dimensional. The forces that act on the premium, as well as the price of an options contract, has several influential factors. To measure these factors or forces that impact the premium or price of an option, there are certain greek metrics. The vega options greek metric is the most commonly used option. In this article, we will understand all about vega options and how they can be beneficial or used to calculate these metrics.
What is Vega?
Vega is a derivative option that stems from implied volatility. It is essentially the measurement of the price sensitivity of an option. This price sensitivity changes depending on the volatility of the underlying asset. It represents the change in volatility with regards to the changes in the contract price of an options contract. The metric of comparison of volatility is a 1 per cent change in the implied volatility of a specified underlying asset. In essence, this volatility is a key measure of the speed and amount of the changes in the price movement. It can also be based on the historical prices, recent changes in price, and also the expected movement of price in a certain trading instrument.
In simple terms, the vega definition is that it measures the sensitivity of options that is implied to volatility. However, it is key to note that Vega should not be confused with volatility. Volatility is either the expected or historic variation in the value of the underlying future. Historical volatility is the volatility of the past. On the other hand, expected volatility is an unknown metric that feeds into the price of the option as implied volatility.
A Peek Into Vega Options
A change in vega can be observed when there are large movements in price with respect to the underlying asset. In vega trading, the vega metric can drop when the option approaches expiration. They are also used by a few traders in the stock market to hedge against the implied volatility value. The option is considered to offer a competitive spread if the vega of an option is higher than the bid-ask spread. The vice versa also holds true. Vega options also let us know about the amount of swing in the price of the option depending on the changes in the volatility of the underlying asset.
The longer amount of time that an options contract has until it reaches its expiration date, the more effect that volatility has on the price. It is purely centred around at-the-money options and falls as it moves in-the-money or out-of-the-money. Usually, options that are dated for a longer period of time have a relatively higher vega value. This is solely a reflection of Vega’s sensitivity to time. However, it is important to know that vega doesn’t have any impact on the intrinsic value of the premium price of an option, It only affects the extrinsic value.
Vega trading is performed to get a clear understanding of the price fluctuations based on volatility and their effect on the extrinsic value. All that Vega does is measure the theoretical change in price for each percentage point move in the implied volatility. There are several option pricing models available that can help in the calculation process of implied volatility. It helps gain insights and a deep understanding of the current market prices and what they estimate the volatility of an underlying asset’s future to be. As implied volatility is broadly a projection, it may potentially deviate from the actual volatility of the future.
Similar to how the price movements of underlying assets in the stock market are not always uniform, vega follows a similar pattern. Vega changes in response to time. As a result, traders who use the method of vega trading usually ensure to monitor the same regularly.
How is Vega Used?
There are two primary use cases for vega options. One of the key uses is to measure volatility and another is for long and short options. Let us have a detailed look into both these use cases.
- Measuring Volatility
When it comes to an options portfolio or any of the multi-leg options strategies, vega can be used as a metric for measuring volatility. Let us consider an example to decode how volatility measurement can be done with vega trading.
For instance, consider long volatility with a Long 1 that has 60 days to expiration at +0.50 vega. On the other hand, consider short volatility with a Short 1 that has 30 days to expiration at -0.3 vega. The net vega for this example would be +0.20 vega. With this value, we can come to the conclusion that this trade is long vega and it also has positive volatility exposure.
- Long and Short Options
Usually, short options have a negative vega and long options have a positive vega. While purchasing an option, the investor would typically want the premium price to increase and when selling an option, a decrease in premium price is desirable. If the implied volatility increases, then the premium of the option would also increase. This is the reason why vega is positive for long positions and negative for short positions.
In a nutshell, a short vega portfolio reflects vulnerability with respect to volatility and a long vega portfolio indicates a positive exposure to the increase in implied volatility.
Vega options can be beneficial in understanding the measure of volatility by gauging the extrinsic value. In no scenario is the intrinsic value of the underlying asset affected. Managing the vega exposure of a portfolio can help gain a clear understanding of the volatility risk and the comfort level of the trader.