Vega is a measure of the sensitivity of the option price with respect to the change in the volatility in the underlying security. Hence, vega represents the volatility of a security.
Option pricing is dependent and affected by 7 variables. They are
- Price of the stock
- Strike price
- Type of option
- Time to expiration
- Interest rates
- Expected volatility
Hence, the volatility of the underlying security is an important variable that affects the option pricing.With regard to volatility, there are two types. There is historical volatility and there is implied volatility.
The table below illustrates the difference between historical volatility and implied volatility.
|Historical volatility||The historical volatility is derived from the standard deviation of the asset’s closing prices over a period of time. This figure is expressed as an annualized percentage figure.|
|Implied volatility||The implied volatility of an asset is derived from the market price of the option itself. This volatility figure is calculated using the Black-Scholes Options pricing Model.|
The historical volatility is used to find out the theoretical option price. Implied volatility is derived from the market price of the option itself. Often times, the market price of the option departs from the theoretical price of the option.
For long option positions, Vega is always positive. ATM puts and calls have an identical vega. A positive vega tells a trader that increased volatility will increase the option premium. A negative vega(short positions) will decrease the option premium when volatility increases. In general, traders would sell premium when implied volatility is high and buy premium when implied volatility is low (studying historical implied volatility).