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Understanding Vega II
Brian Overby
July 25, 2006

A little trivia first about Vega, before we dive into its use. Vega is not actually a Greek letter – but since it begins with “V” and measures changes in volatility, the name stuck as a useful mnemonic. The actual Greek letters that are frequently used for changes in volatility are Omega , Kappa, or Tau, as shown to the left. Vega is actually most commonly known as the brightest star in the constellation Lyra.

But enough trivia! In the last post we finished by discussing the usual characteristics of options with large Vega. Here's a quick summary of the characteristics below:



To give you a more concrete feeling for what this all means, let’s look at two very different stocks, Google and IBM. Google definitely has all the characteristics mentioned above. It is an expensive stock (trading as of this writing at $390) and has a fairly large implied volatility (33%). To compare the two options, you’ll note I selected a further-out series for Google than IBM (September versus August).



First, compare the ATM strike to the In- and Out-of-The-Money strikes. True to our rule-of-thumb for large Vega, the Vega is much larger for the 390 strike: 0.61 or 61 cents. This means if the implied volatility of this option moves one percentage point up or down, the option value will either increase or decrease by 61 cents accordingly.

It’s worth noting the 440 strike Vega is smaller, but it represents a larger percentage of the option’s premium. It is 44 cents on a $5.50 option (8.0%) vs 61 cents on a $22.10 option (2.7%).

Now let’s turn to the IBM August call:



IBM stock is trading at a much smaller figure than Google - $74.86 - and with lower implied volatility of 17%. Here we’re looking at a relatively nearer-term option, August versus September. The Vega for the ATM Strike is .08 or 8 cents - much smaller than Google’s September ATM call.

At the same time, on a percentage basis 8 cents is still a major factor in the price; 8 cents on a $1.45 option equates to 5.5% of the option price. Here’s a great example of what I said in my previous post: “Vega just doesn’t get the respect it deserves.” If the implied volatility of the option contract moves just one percentage point in the wrong direction, this will option lose 5.5% of its value. This situation may cause the most annoying occurrence for option buyers: sometimes you’re right about the direction, but you still lose on the trade because of an implied volatility crunch.

If buying an option and you notice your susceptibility to Vega is high (for example, due to major news events), you might want to do a spread (buy one option and sell another). This way, if a drop in implied volatility is hurting the option you bought, it should be helping the option that you sold – helping curtail the effects of the implied volatility.