Imagine Stock A and Stock B have the same price of $50.00. A call option on Stock A with a strike price of $50 is trading at 0.50, while a call option on Stock B with the same strike and expiration is trading at 5.00. Why does the market call options on Stock B higher than those on stock A? The answer is simple: the market expects higher implied volatility in the company of Stock B.

When IV rises or falls, option prices rise and fall in line with it. But by how much?

What is Vega?

Vega represents an option's sensitivity to changes in implied volatility (IV). Implied volatility is expressed as a percentage, while Vega is always expressed in dollar amount. In other words, Vega tells how much the option value will rise based on a 1% increase in implied volatility.

The Vega value is positive for long options positions and negative for short options positions. Therefore, an increasing IV environment helps long option positions and hurts short option positions.

For example, imagine you bought a "16 Dec $150 APPL call" with 31 days until expiration at the premium of $3.56. If IV were to rise from 38.79% to 48.79% instantly, you might expect the option premium to increase by: 0.1586 X 10= $.1.586 to around $5.146, all things being equal.

Simply put, Vega describes the relationship between option value and implied volatility. If IV rises, options values rise, and vice versa. Vega projects how much the value of an option is expected to change for every one-percentage-point change in IV.

How Vega Differs and Changes

Like the other Greeks, Vega is a snapshot of the option's sensitivity to IV at a specific moment. The following figure shows how it changes over time.

* For illustrative purposes only.

• We can see that Vega is centered around at-the-money and falls as it moves into out-of-the-money or in-the-money. Because ATM options have the highest time value, they will naturally have higher Vegas compared to ITM and OTM options.

• As time passes, there is less time value in the option premium that can be affected by changes in IV. Consequently, longer-dated options have a higher Vega value, meaning Vega gets smaller as expiration approaches.

• Different strikes or expirations will result in different exposures of your position to implied volatility changes.

Be Aware of Volatility Crushes

Suppose you expect a big upward swing in Company XYZ due to its upcoming earnings release. Before the release, you purchase call options on XYZ. Fortunately, you are right, and the XYZ stock gets a nice bump. However, you can still lose money even if you were right in your analysis. Why? Your positive-Vega long option position gets hurt by the decreasing volatility.

Before the earnings report is released, implied volatility generally rises as the uncertainty goes up about whether how underlying security performs relative to expectations. Implied volatility then usually decreases after the figures are published and reduce uncertainty. This swift reduction in implied volatility is known as a volatility crush.

You may be right about the direction of price movement after an earnings report, but if you bought the option in an inflated IV environment, the volatility crush afterward may counteract the benefit of your correct prediction. Conversely, an option buyer can benefit from rising volatility. The Vega value helps you quantify the risk and reward from volatility changes.

Next Step

Learning from practice can help you deepen your understanding of Vega in options trading through practical application. Options Paper Trading supports two basic buying strategies (Long call/Long put) and two basic selling strategies (Covered call/Cash secured put).

If you want first-hand experience seeing how volatility changes can impact options with different strikes and expirations, tap here and get started with paper trading!  

Share your paper trading results and experiences with Vega in the comments!

Disclaimer: All trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations