Option Vega: Implied Volatility Greek Explained

What is Vega?

The markets are in a constant state of flux. Sometimes, they’re relatively quiet, like around the holidays. Other times, they can be incredibly volatile, such as during earnings season or economic announcements like jobs reports.

When security prices fluctuate more than usual, the market is said to be experiencing volatility. Volatility directly impacts the price of options contracts—higher volatility generally leads to higher option premiums, while lower volatility tends to reduce them.

For example, if the price of ABC starts swinging sharply in either direction, implied volatility (more on this next) will likely rise. This increase in price uncertainty will cause the premiums of ABC call and put options to go up. This happens even if the stock price hasn’t moved significantly overall.

Conversely, if ABC’s price remains stable, implied volatility (IV) may drop, leading to lower option premiums. Let’s dig into IV next. 

What is Implied Volatility?

Options traders live and breathe implied volatility, or “IV” as we call it in the industry. IV is a huge factor in pricing options because it reflects the market’s expectations of future price moves in the underlying asset, whether a stock, ETF, or even commodity. 

There are actually three different volatility metrics: 

• Implied Volatility (IV): Reflects the market’s forecast of a security’s future price movement, derived completely from how options are currently priced.  
• Historical Volatility (HV): HV measures how much a security’s price has moved in the past over a specific time period.
• Realized Volatility: This reflects the actual volatility a security has experienced. Realized and historical volatility are often used interchangeably, though HV usually focuses on shorter time frames.

Options traders focus almost exclusively on implied volatility. We don’t care what has happened; we care what may happen, and IV gives us a window into future potential price movements of a security. Let’s see how next.

Implied Volatility Example

Since vega is all about implied volatility, it’s crucial to fully grasp this topic before moving on.

Everything’s relative in trading. To show how implied volatility works, we will compare the option chains of two stocks trading at the same price but with very different IV levels: ABC and XYZ:

As we can see, XYZ has substantially higher IV levels. This tells us that the future price movement of XYZ is expected to be more uncertain (volatile) than ABC. 

To account for the potential for more significant price swings, XYZ options are priced higher than ABC options, even though both underlying stocks are trading at the same price.

Higher IV reflects greater market expectations of price movement, leading to more expensive options due to the increased risk options sellers are taking.

Why is Implied Volatility Higher for XYZ?

So, why exactly is IV higher for the XYZ options? There are innumerable reasons, but here are three common culprits:

• Earnings Announcements: Upcoming earnings can trigger big price moves.
• Market Events: Economic data, Fed interest rate decisions, or geopolitical risks.
• Recent Price Swings: Sharp moves signal the potential for continued volatility.

It’s important to note that high historical volatility doesn’t always mean high implied volatility. For example, a particular stock may only move significantly around earnings. Options expiring between earnings may have low IV, while options expiring right after earnings can have incredibly high IV.

How Does Vega Work?

The option Greek vega measures an option’s sensitivity to changes in implied volatility. It shows how much an option’s premium will increase or decrease for every 1% change in implied volatility.

Let’s take a look at an example to see why this matters. 

You’re long a call option on ABC while ABC trades at $100/share. Remember, vega tells us how much the option price will change for a 1% move in IV.

• Current Setup:
  
  • ABC stock price: $100
  • Call option premium: $2.00
  • Vega: 0.20
  • Implied Volatility (IV): 20%

Now, let’s see what happens when IV changes by 1%:

• If IV Increases by 1%:
  
  • Change in option premium = 0.20 × 1 = $0.20 increase
  • New premium → $2.20
• If IV Decreases by 1%:
  
  • Change in option premium = 0.20 × 1 = $0.20 decrease
  • New premium → $1.80

As we can see, a slight change in IV can mean a big swing in option prices.

Positive vs Negative Vega

For long options, vega is always positive. We can see this on the SPY (S&P 500 ETF Trust) options chain below:

Vega is always positive because an increase in implied volatility (IV) raises the value of all options. Higher volatility means there’s a greater chance the option will move in-the-money before option expiration, which makes the contract more valuable. This applies to both long calls and long puts.

On the flip side, short options have negative vega. This is because rising volatility increases the risk of the option moving against the seller, reducing the profitability of the trade.

• Long options = positive vega: More volatility = higher option value.‍
• Short options = negative vega: More volatility = more risk for the seller.

Vega and Time to Expiration

As we've learned, vega measures how sensitive an option’s price is to changes in implied volatility. But there’s another critical factor that influences vega: time to expiration. 

Options with more time until expiration have higher vega because there’s a greater chance for volatility to impact the underlying price. 

Conversely, options with less time remaining see their vega diminish as expiration approaches, making them less sensitive to changes in implied volatility.

The chart below shows how vega behaves across different expiration cycles and strike prices for SPY (S&P 500 ETF Trust) options, comparing cycles with 1, 2, and 5 days to expiration (DTE).

Vega and Strike Price

Let’s focus on one SPY (S&P 500 ETF Trust) expiration cycle, 7 FEB 2025, to understand the relationship between option moneyness and vega. 

The above chart shows how vega changes as we move through different strike prices. Notice the curved shape, with vega peaking at the at-the-money (ATM) strike and tapering off as we move in either direction. Vega peaks for ATM options (strike price 603 in this example) because the option’s price is most sensitive to changes in volatility.

• In-the-Money (ITM): Vega is lower because the option’s intrinsic value dominates (very little extrinsic value), and volatility changes have less impact on the price.
• Out-of-the-Money (OTM): Like ITM options, vega decreases as the strike moves further from the current price, since there's less chance the option will end up profitable.

Traders targeting volatility prefer these ATM options because they offer the greatest exposure to shifts in implied volatility.

Vega and Option Strategies

Vega shouldn’t be the only thing you look at before placing an options trade. There are other key Greeks to keep in mind, such as:

• Theta – How fast will the option lose value each day?
• Delta – How much will the option move for every $1 move in the underlying?
• Gamma – How fast does delta change for every $1 move in the underlying?

With that said, let’s explore some trading strategies you can deploy to capitalize on vega. As mentioned, traders often prefer to “sell vol,” so we will focus on net credit option trades.

Option Greeks Calculator

Want to calculate your own Greeks? Input some data and give it a try below!

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⚠️ The examples provided in this article are for educational purposes only and do not include commissions or fees, which may impact actual returns. Always understand the risks associated with investing and review The Characteristics and Risks of Standardized Options before trading options.