How does vega work and why does implied volatility matter more than historical volatility for options pricing?
I'm confused about vega. I know it measures sensitivity to volatility, but which volatility — historical or implied? And why do traders say 'I'm long vega' or 'short vega'? How would I calculate the P&L impact of a volatility change on my options portfolio?
Vega is the Greek that measures an option's sensitivity to changes in implied volatility (IV), not historical volatility. Understanding this distinction is crucial for CFA Level II.
Vega Defined:
Vega = change in option price per 1 percentage point change in implied volatility.
If a call option has a vega of 0.15, and implied volatility increases from 25% to 27% (a 2 percentage point increase), the option price increases by approximately: 0.15 x 2 = $0.30.
Why Implied Volatility Matters More:
Historical volatility tells you what already happened. Implied volatility reflects what the market expects to happen in the future. Since options are forward-looking instruments, their prices embed expected future volatility.
- Historical vol = standard deviation of past returns
- Implied vol = the volatility that makes the Black-Scholes price equal the market price
When traders say they're 'long vega,' they profit when implied volatility rises. When they're 'short vega,' they profit when IV falls.
Vega Characteristics:
| Factor | Impact on Vega |
|---|---|
| Moneyness | Highest for ATM options |
| Time to expiration | Higher for longer-dated options |
| Current IV level | Vega itself doesn't depend on IV level |
| Option type | Same for calls and puts (same strike/expiry) |
Portfolio Vega Example:
Mercer Capital holds the following Brightfield Energy options portfolio:
| Position | Quantity | Vega per Option | Position Vega |
|---|---|---|---|
| Long 6-month calls | 200 contracts (20,000 shares) | 0.22 | +4,400 |
| Short 1-month puts | 150 contracts (15,000 shares) | 0.08 | -1,200 |
| Net Portfolio Vega | +3,200 |
If Brightfield's implied volatility drops from 32% to 29% (a 3 percentage point decrease):
P&L impact = +3,200 x (-3) = -$9,600
Mercer's net long vega position loses money when IV falls.
Vega and the Volatility Surface:
In reality, implied volatility isn't a single number — it varies by strike (volatility skew) and by expiration (term structure). ATM options on the same underlying can have different implied vols for different expiration dates, which means your vega exposure has a term structure dimension.
Exam tip: A common CFA Level II question asks you to calculate the approximate P&L from a change in volatility given a portfolio's vega. Remember that vega is always positive for long option positions (both calls and puts) and negative for short positions.
Dive deeper into options Greeks with our CFA Level II derivatives module on AcadiFi.
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