Vega is a Greek that measures an option’s price sensitivity to the change in the volatility.
Vega represents the option contract price change in reaction to 1% change in the volatility. Volatility should not be confused with Vega. Volatility measures the amount and speed at which price moves up and down, and can be based on recent changes in price, historical price changes, and expected price moves in a trading instrument. Historical volatility is a measure based on the historical price so the value is known. Forecast volatility is an unknown volatility in future price, it is estimated as implied volatility in the option price.
The Vega value on Bit.com is denominated in USD.
For example, if the value of an option is $500, implied volatility is at 40 and the option has a Vega of 20. Assume that implied volatility moves from 40 to 45, which means the volatility increase by 5%. Thus, the option price is expected to increase by $100 = 5 x 20 to $600.
A call and a put option with the same strike price have the same Vega value. Vega is the highest when the underlying price is near the option’s strike price and it’s gonna trail off when it goes far out-of-the-money or far in-the-money. This is because the at-the-money option is most speculative, it implies that the option at-the-money is most sensitive to volatility, a little change in volatility at this moment could stir up a greater psychological impact among traders (reflected as a greater change in option price per 1% of volatility change). If a call option and a put option with the same strike price and expiration have different vega values, it means the same change in volatility would cause two different magnitudes of changes in the respective option price, which implies a risk-free arbitrage opportunity according to call-put parity.
Whether the option is in-the-money or out-of-the-money, the Vaga value decreases as it approaches expiration. It means longer dated option is more sensitive to the change of volatility than shorter dated option. It indicates an important principle in the option pricing, i.e. time and volatility are relevant. The time value makes up a large proportion of the option’ value for longer term options.
Whether the option is in-the-money or out-of-the-money, there is a positive correlation between the Vega value and volatility. The main reason is that increased volatility will unconsciously trigger the reaction of investors, as volatility goes higher, the more the option price will move. For the at-the-money option, the possibilities of it becoming in-the-money or out-of-the-money are both approximately 0.5, the impact of volatility is more constant for at-the-money option. Hence, it is relatively easier to predict the price of an at-the-money option in various volatility scenario.
Two major applications of the Vega value: First, vega helps a trader to understand the risk exposure for a single asset or portfolio asset when volatility changes, which is the fundamental significance of this Greek in option trading. Second, vega is useful in building a volatility trading strategy, in which case a trader only trade based on the change in volatility, without having to know which direction the underlying asset price will go in the future,