Option Trading: What is Vega?
Though one of the more esoteric (and difficult to employ) so-called "Greeks" of option trading, vega is a number and concept option traders should at least familiarize themselves with simply to improve their understanding of why option-pricing dynamics change over time, and can change from one strike price or expiry to the next.
Simply put, vega is a measure of the impact changes in the underlying stock's (or index's) volatility may have on that option's price. Vega is numerically expressed as the amount of price change an option may experience solely due to every 1% increment change in that stock's or index's quantifiable volatility.
Yes, it matters.
Option prices - puts as well as calls - tend to be higher when the underlying instrument's volatility is greater. Ergo, when determining a fair value or target price for an option, the current or future volatility and any potential changes in that volatility must be considered.
Example:
ABC shares are priced at $34 in February and the March 36 calls are priced at $1.60 each. ABC's measured volatility is 30%. The vega for that call option has been determined (by a combination of history and another pricing model) to be 0.20.
Were the volatility for ABC to rise from 30% to 31%, the price of the call option would theoretically rise to $1.80. That is, the initial price of $1.60 plus $0.20 for every 1% increase in the stock's volatility. On the other hand, if the stock's volatility had fallen to 29%, the option's price would slump from $1.60 to $1.40... less $0.20 for every 1% decline in volatility.
It's useful to understand what vega is and how it works, but it's also a tough premise to quantify and put into practice simply because it's based on somewhat arbitrary numbers, and the pricing model itself leaves a lot of wiggle room. There are also a lot of other factors that can affect option prices. Never even mind the fact that predicting volatility is tough to do.
Nevertheless, at the very least option traders should understand that changes in a stock's or index's volatility can have a surprisingly large affect on option prices.