How to Use Vega in Options Trading: Vega Trading Strategies

 

In the option market, the price of the underlying security is affected by various factors directly or indirectly with an impact on option premium. Instability in price that is better known as implied volatility is one of the leading factors that affects the option premium price. However, the level of sensitivity of option premium towards the volatility could be different.

Understanding the level of sensitivity or how much the option price is sensitive towards the volatility is important to trade with the right option strategy. Vega is a member of the option Greeks that will help you to understand this sensitivity in options trading. Here we will talk about the Vega, how it works and how to use it in option trading with a few Vega trading strategies.

What is Vega in Options Trading?

Vega is one of the key member in option Greeks, that measures the level of sensitivity against the change in the implied volatility of the market or underlying security. Vega is that value in the option trading that shows you how much option premium price of an underlying security is changed against the 1% change in the implied volatility of the underlying security.

The Vega with a high value of more than 1% means the option premium price n of the underlying security is highly sensitive to the change in the level of volatility. And if the value of Vega is low or you can say less than 1, it means the option premium price is not or is less sensitive against the change in the implied volatility. As the intrinsic value of the option premium is not affected by Vega, it affects the extrinsic value of the underlying.

How Vega Works in Option?

As the Vega measures the changes in option price due to change in the volatility, and when volatility increases the value of option price also increases. A higher level of sensitivity will affect the option price with major changes. On the other hand, a decrease in volatility will influence the option price with insignificant changes.

The volatility affects the price of both options — calls and puts in a similar way. However, calls are highly affected by volatility compared to puts. While the premium of the option contract in-the-money or out-of-the-money is highly affected.

Options contracts with long maturity dates have usually a high percentage of Vega compared to option contracts close to their maturity dates. Hence, at-the-money Vega is higher than out-of-the-money options.

To understand better how Vega works, let’s take an example. Suppose you buy a call option that has a Vega value of 0.10, which shows that every change of 1% in implied volatility will lead to a change in the option price by Rs 0.10, however, other factors remain constant.

On the other hand, if volatility goes down by 1%, it means the option price will move by Rs 0.10 to the downside. If the price of an option premium is Rs 10, and the volatility of the underlying security is 10%, then every 1% change in volatility will change the option premium price by Rs 10.10 and the new volatility would be 11% with the vega value of 0.10.

What is Negative Vega in Options?

The Vega can be expressed with the amount of money as per the underlying security that the option value will increase or decrease when volatility moves up or down by 1%. Vega can be positive as well as negative depending on the impact of vega on option price.

Long options, both calls and puts have the positive Vega, means increase in the volatility also increase the vega and decrease in the volatility leads to decrease in the value of vega. However, in selling options both calls and puts have the negative vega and work in the opposite way. When volatility increases, vega decreases, and when volatility decreases, vega increases.

How to Use Vega in Options Trading?

The Vega can provide you with the level of sensitivity of option price towards the implied volatility. But the question right here is how you can use the Vega in options trading to make the best use of this option in Greek. However, you need to understand how Vega can help you in options trading with Vega trading strategies for various market conditions.

To Measure the Volatility Level

One of the most important applicability of Vega is, that you can use it to measure the volatility. Yes, when you try to enter into a trading strategy, you need to measure the volatility of the underlying security. For any multi-leg options strategy, you can use the Vega to measure the sensitivity of option premium price towards the implied volatility of the underlying security.

To Understand the Market Sentiment

You can also use the Vega to measure the sentiment of the market using the implied volatility that helps to know the expected change in the market movement. When the value of vega is high, it means there could be a swing in the price movement in coming trading sessions.

Low vega shows the market sentiment quite stable, the price movement of underlying security is not sensitive towards the implied volatility. While high vega shows the uncertainty in the market signalling the traders to choose the right trading strategy or align the strategy based on the implied volatility and sentiment of the market towards the underlying security.

To Select the Right Options

The Vega affects the option premium, as the rise in the implied volatility indicates the uncertainty in the market. You need to understand how Vega affects the option premium of the underlying security and changes in Vega influence the price of the option premium.

And with the help of Vega and how it affects the price of the option premium, you can use it to select the right option and strike price. You can use the Vega to find out the options that will benefit from an increase in the level of volatility. In anticipation of upcoming market news, you can pick the right option having the high Vega likely to benefit from high volatility.

To Enter into the Long Position

You can also use the Vega in entering into long positions in option trading. Yes, if you have the positive Vega, you can enter into the long positions. If Vega is positive, there are higher chances of the movement in the price of the option premium and it good option buyers.

Positive Vega with a high level of sensitivity shows, that the underlying security is highly sensitive towards volatility. Hence, when volatility is high with high Vega, the price of the option premium has a higher chance of moving in the upward direction.

To Enter into Short Trade Position

While on the other hand, if the Vega is negative you can use this to enter into short positions. As the negative vega means, the volatility is very low and the option premium will not show any significant movement before the expiry, as the volatility level is very low.

When Vega is negative, it means the option premium price is less sensitive towards the implied volatility. And if the option premium does not show any significant movement, it will expire worthless which would be good for the option sellers. Hence, negative Vega means you can enter into short positions in options trading to make profits from selling.