InvestorQ : What is option Vega and how to interpret it in practice?

# What is option Vega and how to interpret it in practice?

2 years ago

The option's Vega is a measure of the impact of changes in the underlying volatility on the option price. It measures the sensitivity of the option to changes in volatility. Typically, both calls and put options react positively to volatility. Specifically, the Vega of an option expresses the change in the intrinsic value of the option for every 1% change in underlying volatility. The reaction is positive for both calls and put values.

Options tend to be more expensive when volatility is higher. Thus, whenever volatility goes up, the price of the option goes up and when volatility drops, the price of the option will also fall. Therefore, when calculating the new option price due to volatility changes, we add the Vega when volatility goes up but subtract it when the volatility falls. Let us look at the impact when volatility rises by 5%.

 Simulating Option Greeks on Reliance Industries 1100 Strike Underlying Price 1110 Underlying Price 1110 Exercise Price 1100 Exercise Price 1100 Today's Date 27-11-2018 Today's Date 27-11-2018 Expiry Date 06-01-2019 Expiry Date 06-01-2019 Historical Volatility 20% Historical Volatility 25% Risk Free Rate 6.00% Risk Free Rate 6.00% Dividend Yield 1.35% Dividend Yield 1.35% DTE (Years) 0.11 DTE (Years) 0.11 Call Option Put Option Call Option Put Option Theoretical Price 37.5093 21.9411 Theoretical Price 44.6401 29.0719 Delta 0.5975 -0.4025 Delta 0.5841 -0.4159 Gamma 0.0053 0.0053 Gamma 0.0042 0.0042 Theta -0.4582 -0.2785 Theta -0.5470 -0.3673 Vega 1.4220 1.4220 Vega 1.4333 1.4333 Rho 0.6846 -0.5130 Rho 0.6605 -0.5371 Delta is the sensitivity of the option value to changes in Stock Price Theta is the sensitivity of the option value to Time Decay Vega is the sensitivity of the option value to changes in Volatility

In the above case, how much does the stock option value react to the changes in the volatility? Now in the above case, volatility has shifted up by 5% from 20% to 25%. That means the change in the option price will be (Vega x Rise in volatility). If you apply this formula to the option price, you will see that this exactly captures the shift in option premium. It works both for call and for put options.

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