Implied volatility and vega both measure volatility but they have some differences. Here’s some insight from an education coach at TD Ameritrade.
Hey Coach! I’m trying to analyze different options strategies by looking at implied volatility and vega. What’s the difference between the two, and how can I use them to decide which options to trade?
Both implied volatility (IV) and vega are important when analyzing an options position, but their differences may not be obvious. Simply put, both provide information about how a given option or options position may react in the future, and both are products of an options pricing model. Let’s start with IV.
When a set of variables like underlying price, strike price, days to expiration, interest rates, and dividends are crunched through an options pricing model like Black-Scholes, one value that can be back-solved is IV. The math is complex, but ultimately the IV value that comes out of this formula estimates how much the underlying asset could potentially move in the future.
IV also tells you how much time premium is built into the price of a given option. And with that information, you can compare the current level of IV to the historical range of volatility for that security to determine if the options price is “cheap” (more suited to buying premium) or “expensive” (more suited to selling premium).
Now, while IV tells you how much a stock might move in the future, vega tells you how much the options price may change as IV changes. For example, let’s suppose that:
Because the value of the option is $500 ($5 x 100 shares per option), if IV rises from 40% to 50%, the value of the option would be expected to rise by $10 (vega of $1 times a 10-percentage-point increase in IV) to $510. If IV declines from 40% to 30%, the value of the option would be expected to decline to $490.
Ideally you would buy premium when IV is low and vega is positive. If IV rises after you enter the trade, the value of your position increases because of vega (higher volatility). Conversely, you’d ideally sell premium when IV is high and vega is negative. A subsequent decline in IV would then work in your favor.
Vega doesn’t exist in a vacuum. When volatility changes, it’s usually working in concert with changes in the stock price and time itself, each with their own greeks (delta and theta). Find out about the interplay of the greeks during the life of a trade.