How Vega can help you manage your Option portfolio

Measures the risk of changes in implied volatility or the expected volatility of the underlying asset price. Vega is majorly affected by volatility.

When volatility increases the stock price or the index price starts swinging heavily. Suppose a stock is trading at hundred rupees and if there is an increase in volatility the stock price can start moving between 80 and 120. So, when stock hits 80 put option sellers fret as it now might expire in the money. Likewise, if stock price moves to 120 call option writers fear that it might expire in the money. By now you know call and put option sellers benefit only when option expires out of the money. Irrespective of call or put option when volatility is high the option premiums have a higher chance to expire in the money.

The effect of increase in volatility is maximum when there are more days for expiry. It would be a good idea to write these options and collect the premiums and pocket the difference in premium. If option premiums are not moving as much as the volatility index, we need to look at the time left for expiry.

With increase in volatility premiums increase but by how much is the question. Here comes in our friend Vega to calculate this. The Vega of an option measures the rate of change of options value of premium with every percentage change in volatility. Increase in volatility would increase the option premiums. So, Vega has a positive number for both calls and puts.

For example, if the option has a Vega of 0.15 then for each percentage change in volatility the option will gain or lose 0.15 in its theoretical value.

For a better understanding let's considering an example: Suppose a stock is trading at Rs 475 and you want to write 500 CE and there are 10 days for expiry. Clearly there is no intrinsic value but there is time value. Assume option is trading at Rs 20 and there is an event coming up which might increase volatility so the risk of in the money expiry is more. So, you may lose the option premium collected. However, if the premium was high like 30 or 40 you might think of writing the option as premium is relatively high. Option writers expect the higher premiums for writing option. To summarise Vega and volatility go hand in hand.

(The author is a homemaker, who dabbles in stock market investments in free time)