2. Vega

Introduction

Vega measures the rate of change in an option's price based on movements in implied volatility. For example, if a call option has a Vega of 0.10, its price is expected to increase by $0.10 for every 1% rise in implied volatility. Traders analyze Vega to gauge an option's sensitivity to volatility, and create trades that capitalize on volatility changes. Understanding what impacts Vega is crucial for actively trading volatility through options strategies.

Vega Ranges and Moneyness

An option's Vega value depends on its moneyness. Deep ITM call options have relatively low Vega, in the 0.01 to 0.03 range. This is because they have little extrinsic value remaining. ATM call options have the highest Vega, typically between 0.08 and 0.15. More extrinsic value makes ATM calls highly sensitive to volatility. For deep OTM calls with a low chance of profit, Vega falls back to 0.01 to 0.03.

Put options exhibit a similar Vega pattern. ITM puts range from 0.01 to 0.03, ATM puts are elevated from 0.08 to 0.15, and OTM puts are near 0.01 to 0.03. The moneyness relative to the strike price determines an option's Vega exposure.

Impact of Implied Volatility on Vega

Implied volatility has a direct relationship with Vega. As implied volatility rises, Vega of almost all options increases since higher implied volatility signals a wider potential trading range. Mathematically, Vega is proportional to the square root of time to expiration. It is important to think about moneyness with respect to how IV may impact Vega. For ATM options, vega stays relatively consistent even with a large move in IV. For OTM and ITM options, an increase in IV will increase the vega of the option.

Effect of Time Decay on Vega

Time remaining until expiration also affects Vega. Longer dated options have higher Vega since more time equals greater volatility exposure. Specifically, Vega declines as expiration approaches following a convex curve - slowly at first and then rapidly in the last 30-60 days. 

For example, an ATM option with 180 days to expiration may have a Vega of 0.14. At 60 days out, Vega could drop to 0.10. Then at 30 days, it falls further to 0.05. Traders implement volatility strategies largely using front month contracts to target high Vega.

Vega Trading Example

Here is an example of trading volatility using Vega. A trader buys an ATM call option with a 0.12 Vega when implied volatility is low at 20%. The option price is $2. Over the next week, IV rises 15 points to 35%. Given the option's Vega of 0.12, its price should increase by approximately 0.12 * 15 = $1.80. The trader sells the call for $3.80, profiting from the IV expansion.

Conclusion

Vega indicates an option's price sensitivity to implied volatility changes. Moneyness, implied volatility, and time impact Vega values. Traders implement volatility arbitrage strategies using a combination of Implied volatility and Vega to capitalize on overpriced or underpriced volatility across the options volatility surface.