How does vega work and why does implied volatility matter more than historical volatility for options pricing?

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.