InvestorQ : What is option Vega and how to interpret it in practice?
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Niti Shenoi made post

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

Answer
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Archita Jajjoo answered.
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.