In recent articles we covered delta and gamma, important Greeks that option traders should look at before trading options. Both delta and gamma are related to the sensitivity of an option’s price to changes in the price of the underlying asset. The difference between the strike price of an option and the price of the underlying asset gives us a measure of the intrinsic value for that option, but other factors add value to the option as well. An option derives value from the probability of maturing in-the-money and thus any factor influencing this probability influences the option price, which is part ofthe extrinsic value of the option.
One of the most important value drivers for the extrinsic value of an option is the implied volatility of the underlying asset. The higher the volatility of the asset, the larger its movements and speed of change. If you consider two different options with a strike price of $20, both on stocks priced at $18, the option on the more volatile stock should be valued higher. For example, stock A has such a low volatility that it never moved more than one cent a day for the last five years. If the option is maturing soon, such as in five days, it should be valued near zero–-it’s unlikely that the option would overcome the $2 difference to mature inthemoney. Now consider stock B, which has a very high volatility. Just a few days ago, it was trading near $15 and now trades at $18. It’s clear that the higher volatility gives some value to the $20 option because there is a larger probability that the option will end in-the-money.
If volatility is an important factor in the extrinsic value of an option, any change in volatility may affect the option’s value. Certain occurrences–such as an earnings report, economic report, or a political event–can significantly change the implied volatility of a stock. Any of these occurrences may induce a rise or a fall in implied volatility and thus in an option price. We can use vega to measure this effect. Vega measures the sensitivity of an option’s price to changes in volatility. It shows the change expected in the option’s price in reaction to a 1% change in the volatility of the underlying asset.
Vega is positive for call options and negative for put options. At the same time, as maturity approaches, vega declines because a larger proportion of the option’s value comes from intrinsic value, which doesn’t depend on vega. When an option is far from maturity, buyers have more opportunities to see the option ending in-the-money, which increases the risk for the seller. The result is an increase in the needed compensation and thus the option price. This compensation is directly related to risk (volatility).
In terms of moneyness, vega tends to zero as the option goes deeper in-the-money or farther out-of-the-money. When the option is far from being near or atthemoney, it becomes less sensitive to changes in volatility.
Let’s consider an example with Microsoft trading at $35 and with you holding a call option with a strike price $36, valued at $2. Suppose the option has a vega of 0.8. If Microsoft’s implied volatility rises 5%, your option should roughly move by 0.15 x 5, or $0.75. The new price would then be $2.75.
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