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What is Vega in Options Trading

25 Sep 2023


Of late, the Indian equity markets have become highly popular. With the value of indices constantly breaching their all-time high figures, investors from all across the globe are trying to gain an advantage and earn healthy profits. Several new domestic investors have also started investing in shares and mutual funds to make extra money.

But do you know buying and selling shares is not the only way to make money from the equity markets? You can also trade in the derivatives segment, primarily Futures and Options (F&Os). They allow you to gain considerable returns in short durations with limited investments. You can even double or triple your investment within a few weeks.

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However, you must know that trading in options involves high risks. You can even lose your entire capital within a few days if you aren’t diligent enough. Hence, it’s vital to understand how options contracts work and the factors that drive their price movements.

How do Options work?

In the world of the stock market, options are the derivative contracts that give you the right (but not an obligation) to buy or sell underlying assets at a specified price (known as the strike price) on or before a fixed date (known as the expiry date). If you are bullish on an underlying asset and feel its price can rise soon, you can buy a Call Option. Similarly, if you are bearish on an underlying asset and perceive its price can decline shortly, you can buy a Put Option.

When you buy an option, you must pay the seller a premium. This premium is also known as the price of an options contract. An option’s premium can increase or decrease with heavy volatility till expiry. Several factors, including the underlying asset's price, market volatility, time decay, and the interest rate, cause these changes. A set of parameters – Options Greeks – measures the impact of different factors on an option’s premium.

Understanding Vega in Options Trading

Vega is one of the five Options Greeks, the other four being Alpha, Gamma, Theta, and Rho. These Options Greeks are collectively used to measure the impact of various factors on the price of an options contract.

Among these, Vega is one of the most critical Option Greeks. You can use it to measure the connection between an option’s premium and implied volatility. In other words, Vega Options Greek indicates how the price of an options contract changes relative to the implied volatility in the underlying asset. A higher Vega value means an option is highly sensitive to the implied volatility in the underlying asset and vice versa.

Now, the question that arises here is what is implied volatility. It refers to the market’s forecast of an asset’s price movement. It is based on the people’s sentiments, i.e., what people think about a stock at a given time. Low implied volatility means that investors are not expecting too much of movement in a stock. Whereas a high implied volatility means investors expect erratic movements in the short term.

How to use Vega for options trading?

Vega indicates the impact of implied volatility in an underlying asset on the price of the options contract. For instance, if the value of Vega for an options contract is 0.20, it means that the price of this option will change by 20 paise when there is 1% implied volatility in the price of the underlying asset. Should implied volatility increase by 1%, the option’s price will rise by 20 paise, and if the implied volatility decreases by 1%, the option’s price will decline by 20 paise.

Remember that implied volatility has nothing to do with the underlying asset's price. It only reflects what investors feel about an asset.

So, when you buy an options contract, multiple forces start working on it, causing its premium to rise or decline. It may happen that the underlying asset's price is moving in your direction but the option’s premium is budging in the opposite direction. This can happen because of the Vega. In such a case, you may need high volatility in the underlying asset to gain profit from your options position.

To conclude

Vega in options can help you understand the impact of implied volatility on your option’s premium. You can also use it to measure volatility while implementing multi-legged options strategies.

With Motilal Oswal, you can open a free Demat account and trade in stocks and derivatives seamlessly.


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