Asteria Essentials # 6 - Options Vega

👋 Hello Asterians,

Thanks for stopping by for another episode of the Asteria Essentials series…

Continuing with the Segment on Options Greeks, we have covered Options Delta and Options Gamma. Today, we’re covering the third Greek i.e. Options Vega.

What Exactly Is Options Vega?

Sounds more like a cranky cousin of Delta, eh?

Vega, also known as Kappa, is an option’s sensitivity to a 1% movement in the implied volatility, and it shares uniformity between both calls and puts.

Explaining it in Asteria terms,

We all know that when the price of a specific asset begins to fluctuate rapidly, the volatility of the said asset increases dramatically and in an unpredictable manner.

Let’s Take Up Scenario A to Understand Better,

We have two talented options writers — Astrid and Claire. Astrid is writing put options, and Claire is writing call options.

Let’s say🥝token is trading at $10K. On the same day, there is increased volatility has caused🥝token to fluctuate anywhere between $9K to $11K.

In the first case where the price of🥝token appreciates to $11K, call option writer Claire goes into a frenzy since her call option now has a much greater likelihood of expiring in-the-money.

In the second case, where the price of the🥝token depreciates to $9K, put option writer Astrid also goes into a panicked state since her options are more likely to expire in-the-money.

What is the key takeaway from this scenario?

From the above scenario, we can easily conclude that both call and put options are more likely to expire in-the-money when the volatility of the underlying asset increases.

So How Does the Concept Apply to Options Trading?

To understand better, let’s take scenario B.

Let’s say we have a trader named Mr. Jones, who wishes to write a few call options since 🥝token is trading at $10K, and it is expiring in 10 days. This situation for Mr. Jones holds a time value. But there is another pickle here — there is a huge Fed convention taking place in that span of 10 days.

How?

Well, let’s the options premium is at $530 — what do you think would be the best plan of action for Mr. Jones?

Let’s say if Mr. Jones did write the option and gained the $530 premium. Take into account that the fed convention will cause crazy volatility increases in the market. Is it lucrative for him to take this route?

Not really, because now that the volatility has increased, there is a higher chance for Mr. Jones’s call options to expire-in-the-money. This means there is a higher likelihood for him actually to lose that $530 premium.

In this case, when options writers are forced to stick in a dilemma caused by increased volatility, how could they be incentivized to still write options?

Well, the answer is pretty simple, writers can up the premium!

Higher premiums for increasingly volatile market conditions

When market volatility increases or is highly likely to increase, there is a heightened state of paranoia among option writers who fear that their options might expire in-the-money. And it is in such situations that option writers begin to expect a higher premium for writing options.

So we can safely say that increased volatility >> increased fear of options expiring ITM >> higher premiums.

So how do options traders estimate how much the price of the option will increase/decrease relative to the increase/decrease in price volatility?

Answer - with the help of our third greek - Vega!

Vega

Vega is the greek that measures the risk of increased volatility or expected volatility increase of the underlying asset price.

So there is a greek that measures the real-world or real-time price change i.e. delta. And unlike delta, vega measures the expected/potential/predicted changes in valuation in line with the volatility at that point in time.

So options buyers profit from the decrease in expected volatility, but option sellers don’t.

Also, let’s keep in mind that the implied volatility represents the overall price action in the market, which means when the option price goes up, you can expect more buyers with higher volatility.

So what kind of options are more prone to be Vega exposed?

Options that are closest to being at-the-money (closest to the price of the underlying asset price) — have the higher Vega values;

Similarly, options with more time to expire will have larger vega values. Hence, long-term options may have increasingly volatile price changes with increased volatility. This is because such options with longer expiration have less intrinsic value and more extrinsic value.

Why would this be? Let’s assume there are two options, Option A = $0.75 extrinsic value and Option B = $0.25 extrinsic value, and both of which reach $0 when the implied volatility is at 0%. Option A will be losing $0.75 to get to $0, but Option B only loses $0.25. Hence option B holds a higher vega value.

And with the example, we wrap this episode of Asteria essentials.

Next up, we’ll be discussing the fourth Greek — Option Theta!

Until then, stay curious!

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Asteria, committed to be one crucial component of DeFi infrastructure, defines decentralized protocol of option pricing, trading and hedging of AMM mechanism, and provides APIs and templates for structured option application developments.

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Asteria, committed to be DeFi infrastructure, defines decentralized protocol of option pricing, trading and hedging of AMM mechanism

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