By Darrell Martin
Greeks are just a fancy way to say a math formula to measure or explain a price movement. In the introduction to this series, it was explained how there are many Greeks mentioned in trading. This series will focus on the five most common. This article will explain Vega in simple to understand, English terms.
Vega is actually not a Greek letter, but rather a constellation. In trading, it refers to the amount the value of the option will change for a one-point change in implied volatility or the expected movement. So, if the expected movement in an option changes, it will change the price by so many cents in implied volatility.
Vega is the most powerful Greek. It can override all of the other Greeks. It is more powerful than direction of movement and time, because of implied volatility. Vega is higher on options that are further from expirations, closer to the money.
News can cause the market to move and if the market has already been moving, it may continue to move in the same direction or change direction, which is still expected movement or implied volatility. Implied volatility can go up based on current volatility or based on some news or event that is going to come out.
Implied volatility is highest right before an earnings announcement is released and after any big falls in a stock. Implied volatility can be charted. It is based on the demand for the option and the expectation of how much it may move in that certain time frame. To explain further, if Vega is .05, then for every .01 change in implied volatility, the option will increase or decrease in value by five cents.
A volatility crush is buying an option on high premium and then having it drop quickly. For example, if Fred bought an option the day before an earnings announcement release, the implied volatility will be high. The expected movement is high because of the announcement, but after the earnings announcement, the move will have happened and the expected volatility (movement) will be low. If Fred bought right before the earnings release, even if the Delta (more on this in another article) move made him money, the Vega decrease, due to the drop in implied volatility, could still cause the option to decrease in value.
Vega is directly tied to implied volatility, the expected movement. Vega tells the amount the value of the option will change, for every change in the implied volatility, either increase or decrease.
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