What is vega and how does implied volatility effect it?
Vega is an option’s sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an option contract’s price changes in reaction to a 1 percentage point change (not a 1% change) in the volatility of the underlying asset.
AN EXAMPLE
For example, take a call option an let’s say we are long it. It’s value is $1.00.
The vega associated with it is in this example $0.10. Implied vol is 25%. If implied vol increases from 25% to 26% our call theoretically will now be worth $0.10 more or $1.10. If implied vol goes from 25% to 24% we will theoretically lose $0.10 and our call will be worth $0.90.
The opposite will be true if we had a short position. If we are short a call (short vega) we theoretically increase the value of our position should IV down and theoretically lose value if IV goes up.
THE BOTTOM LINE
We always have to keep vega in mind when putting on directional bets, especially if the directional bet has some “event premium” such as earnings priced into it. If we expect implied volatility to materially change, we must factor that into our entry methodology.
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