Vega is the Greek that measures the impact of change of Implied Volatility on the price of an option. Specifically, it quantifies how much a 1% increase in volatility will move the option premium. Generally, an increase in volatility will make option prices increase.
Vega is a positive value. When volatility increases, option prices increase. This means that option buyers with long option positions have positive Vega positions, while option sellers with short option positions have negative Vega positions.
However, volatility increases often accompany changes in underlying prices, so it can be challenging to understand how much an option price changes due to volatility and how much from the underlying price change. Still, sellers of options generally are looking for volatility to decrease.
Option prices are mostly proportional to implied volatility, so at first glance, Vega may not seem like that important of a Greek value. But, the value often comes when looking at the combined value of several different option contracts to see how volatility will impact the total position. The positive Vega values of long positions are countered by the negative Vega values of the short options.
For example, a ratio spread is made up of different numbers of contracts of two different strikes, where the trader has bought one strike and sold another. As the underlying price moves, the trader would be wise to understand how volatility changes will impact the combination.
When volatility is low, and more likely to go up, what will the impact be on the position, or the total portfolio? It would be good to have positive Vega for an anticipated increase in volatility. Or when volatility is very high right before a big announcement, how will the likely volatility collapse after the announcement impact an option position? Negative Vega positions will benefit from decreasing volatility.
Vega can be added, subtracted, and multiplied for a single underlying security to find a total Vega for a position. To combine Vega for a total portfolio of multiple underlying securities, there are a few different choices. The simplest choice is to just add the Vega values of each security with all the other Vega values. For most situations, this is probably sufficient. However, some traders like to take into account that options with different Implied Volatility values will respond to overall changes in market volatility differently. For example, if VIX increases by 1%, IV for all positions will likely not change by the same amount. Vega values could be IV and Beta weighted for the most accurate analysis, similar to Delta price weighting. For Vega, Beta of the underlying is a key component of weighting, as Beta is the relationship of the correlation of volatility of price movement between different securities. So, Beta is especially useful for comparing Vega between two different underlying security option positions. Then adjusting Vega to account for the difference between IV of each position and VIX allows a trader to estimate how much a change in VIX will impact each position and tie it back to equivalent change of SPY or SPX. The webpage on Greek Arithmetic takes this on in more detail.
I think it is fair to say that most traders don’t pay much attention to Vega in the Greek values in the option tables. It falls behind Delta and Theta in most analysis. However, an option trader must realize that there are three primary movers of option prices- changes to underlying security prices (Delta), passage of time (Theta), and changes in Implied Volatility (Vega). So Vega should be viewed as similar in importance to Delta and Theta.
I now regularly check the Vega of my portfolio and compare to the current level of market volatility as measured by VIX. When VIX is low, I want my portfolio Vega to be positive, to benefit from increasing volatility. When VIX is high, I want to have a negative portfolio Vega to gain from an expected collapse in volatility.
One of the main considerations when choosing a strategy is the volatility environment. Wise traders modify their approach based on whether volatility is high or low, if it is rising or falling. Given the importance of volatility, having Vega as a measure of the impact of volatility change can be extremely helpful.
