Futures contracts can be an effective and efficient risk management or trading tool. Their performance is basically two-dimensional, either you are up money or down depending on the entry price point and whether the market is up or down versus your position.
But with options on futures there are more dimension, or forces, acting on the price or premium of the option.
There are metrics to measure how each of these different forces impacts the premium of an option. These metrics are often referred to by their Greek letter and collectively known as the Greeks.
Vega is the Greek that measures an option’s sensitivity to implied volatility.
It is the change in the option’s price for a one-point change in implied volatility. Traders usually refer to the volatility without the decimal point.
For example, volatility at 14% would commonly be referred to as “vol at 14.”
Volatility should not be confused with Vega. Volatility is either the historical or expected bounciness of the underlying future. Historical volatility is volatility in the past and is therefore known. Expected volatility is unknown volatility in the futures contract that feeds into the option price as implied volatility.
Whereas, Vega is the sensitivity of a particular option to changes in implied volatility.
For example, if the value of an option is 7.50, implied volatility is at 20 and the option has a Vega of .12.
Assume that implied volatility moves from 20 to 21.5. This is a 1.5 volatility increase. The option price will increase by 1.5 x .12 = .18 to 7.68.
Conversely, if volatility dropped from 20 to 18. This two-point decrease times .12 equals .24, making the option premium 7.26.
Vega is the highest when the underlying price is near the option’s strike price. Vega declines as the option approaches expiration. The more time to expiration, the more Vega in the option.
If you are going to trade options, Vega is a measurement you will want to study.
Peter Knight Advisor