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Vega

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The vega of a derivative shows how the value of the derivative changes in respect to a one percent change in the implied volatility of the underlying. Vega is expressed in dollars. When buying or selling an option, a change in implied volatility means that the option price must be increased (i.e. by the vega amount for each 1% increase) or decreased (i.e. by the vega amount for each 1% decrease) in order to accommodate for a new volatility sensitivity. For example, ABC Inc. is trading at $37 in May and a June 40 call is selling for $3. Assume the underlying volatily is 20% and the vega is $0.35. If the underlying volatility increased by 1% to 21%, the trader will need to increase its option price by the vega amount to $3.35 (i.e. $3 + 0.35) to compensate for the change in volatility. As the option approaches its expiration date the vega of the option will decrease because any volatility changes in the underlying will have a relatively smaller time to influence the price of the underlying asset. The vega is also at its highest when the underlying is equal to the strike price of the option. As the price of the underlying asset deviates further away from the point where no gain or loss would occur, the vega drops. The vega drops because as the underlying moves away from the strike price, it becomes less likely that increased volatility will substantially alter the payoff of the option.



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