What it means
Options are worth more when markets are expected to be volatile, because bigger price swings make it more likely that the option will end up valuable. The sensitivity of an option's price to a change in expected volatility is called vega, and it is usually quoted as the change in value for a one percentage point move in implied volatility, which is the volatility level the market price implies.
A trader holding many options has a total vega equal to the sum of the vegas of each position, with long options contributing positive vega and short options contributing negative vega. If total vega is positive, the portfolio gains when volatility rises and loses when it falls.
To become vega neutral, the trader adds positions that offset the existing vega. A portfolio with positive vega can be neutralised by selling options, and one with negative vega can be neutralised by buying them.
The adjustment is not free of side effects. Options also carry delta (sensitivity to the underlying price) and gamma (sensitivity of delta), so the hedge must be checked for these as well, and traders often aim for a portfolio that is delta neutral and vega neutral at the same time.
Vega neutrality is not permanent. Vega changes as the underlying price moves and as time passes, and volatility does not move equally across different expiry dates, so the position needs to be reviewed and adjusted regularly.
The concept matters beyond trading desks. Companies with option-based hedges, structured products or employee share schemes can find that their accounting values swing with volatility, and understanding vega helps explain why.
In practice
Real-world examples.
Example
An options market maker ends the day with a book that gains if volatility rises. She sells a set of options on the same stock to bring total vega to zero. She goes home without a view on whether markets will become more nervous.
Example
A fund that sold options to earn premium finds that its total vega is strongly negative, so it loses when volatility spikes. The risk manager asks the fund to buy options to reduce the exposure. The fund agrees to a vega limit.
Example
A corporate treasury holds a collar and a few other option hedges whose values appear in its accounts. The finance team calculates the net vega to see how the reported hedge values would change if market volatility jumped. They explain the potential swings to the audit committee in advance.
Formula
Calculation
Portfolio vega = Sum of (Number of contracts x Vega per contract)
Contracts to trade to reach vega neutral = Portfolio vega / Vega per contract of the hedging option, sold if the portfolio vega is positive
A trading book has a total vega of +$4,000, meaning it gains $4,000 if implied volatility rises by one percentage point. The hedging option has a vega of $0.50 per share, and each contract covers 100 shares, so vega per contract = 0.50 x 100 = $50. Contracts to sell = 4,000 / 50 = 80. After selling 80 contracts, the hedge vega is -80 x 50 = -$4,000, so net vega = 4,000 - 4,000 = $0. The trader must then check the delta and gamma that the new position added.Case study
Seen in the real world.
This illustrative story involves a fictional trading firm, Whitestone Derivatives, whose options desk had accumulated a vega of -$25,000 per percentage point through selling options. When a surprise event pushed volatility up by 8 percentage points in a week, the desk lost about $200,000 on this exposure alone.
The head of risk set a rule that the desk's vega had to stay within plus or minus $5,000, and the traders began to hedge at the end of each day by buying options with longer expiries.
When volatility rose again some months later, the desk's losses were small. The fictional case also showed that the desk needed to hedge across different expiry dates, since volatility in short-dated and long-dated options did not move together.
Watch out
Common mistakes.
- Assuming vega neutral means risk free. The portfolio can still lose money from changes in the underlying price, time decay and other factors.
- Hedging total vega but ignoring expiry dates. Volatility in short-dated and long-dated options can move differently, so the vega should be balanced across maturities.
- Setting the hedge once and forgetting it. Vega changes with price and time, and the hedge must be adjusted.
Questions
People also ask.
What does vega measure?
It measures how much an option's price changes for a one percentage point change in implied volatility.
Is vega the same as volatility?
No, volatility describes how much a price moves, while vega describes how much an option's value responds to changes in volatility.
Can I be both delta neutral and vega neutral?
Yes, traders often combine different options and the underlying asset to bring both measures close to zero.
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