I don’t watch much TV. When I do it is usually either MSU basketball (they lost the other night to Indiana) or something my kids are watching on the Disney Channel. However there is one show I have gotten rather attached – “Gold Rush” on the Discovery Channel. If you have not seen it follows crews of prospectors in Alaska as they mine for gold. Tonight is the final episode and apparently someone hits the mother lode. Sort of like having those out of the money options that suddenly go into the money.
Today we cover our final greek in our overall basics review – vega. Of all the greeks, this is the one that seems to cause the most confusion. Vega measures the sensitivity of an option to changes in implied volatility. If we remember from a few weeks back, implied volatility is how option prices change based on the perception in the option market of risk looking forward. As risk perception increases, implied volatility rises causing option prices to rise. If we own options this is good for us as our options become more valuable. When we buy options we get long vega and when we sell options we get short vega. So vega is a number that can be interpreted as how much we would make or lose if implied volatility rises by 1%.
For example, if we have a vega of +100 then if implied vol goes up 2% then we would theoretically make $200. If volatility drops than we would lose money. If we are -200 vega then if volatility rises by 1% we would lose $200.
Vega, like gamma and theta is greatest at the money. Since vega only is based on the extrinsic value of the option, the more extrinsic value the greater the vega. Hence, as we go out in time vega increases for all options. That means that for any given change in implied volatility there will be a greater affect on option prices. The importance of vega and implied volatility cannot be overstated. As I have stated in the past, implied volatility along with price movement account for nearly all the effect on changes in options prices. Watch your vega and use it to help evaluate risk going into a trade as well as why your P and L is doing what it is doing.