Vega is generally the most important risk for a Volatility trader. This is because it is the input into the options model that the trader can control. Implied Volatility is a measure of the future expected volatility of the underlying asset. As investors buy options, the Implied Volatility goes up, and the impact of these moves in Implied Volatility is measured by Vega.
Vega is expressed as the PnL impact for a 1% move in the Implied Volatility of the option. Traditionally, Implied Volatility drops as equities rally and increases when the market is selling off. This is because put options tend to be used as insurance for equity positions. If you are driving your car with no imminent threat, you will shop for cheap car insurance, but if you have lost control of your car and are about to slam into a wall, you will pay any price to reduce your loss. Such is the nature of put options – when the market seems to be spiraling out of control, people will panic to reduce exposure.
Implied Volatility is a key element when determining how you want to construct your trade. You have to decide if you think Implied Volatility is too low as well as how you think Implied Volatility will change as your thesis plays out (or as your thesis fails to play out). If Implied Volatility is low and you are bearish, then buying Vega is generally a good idea. If Implied Volatility is high and you are bullish, then selling Vega is generally a good idea. But, as always, each trade has its own nuance. And figuring out whether Implied Volatility is too high or too low is not the easiest thing to do.
We’ll dive into that later, but the key thing to remember here is that the Vega of an option is the dollar change in the option for a 1% move in the Implied Volatility of your option.
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