Vega: It's Not the Number You're Thinking

We all know that vega is Greek for volatility. Right? Well, no. In fact, not only is vega one of the most misunderstood options “greeks,” it isn’t even a Greek letter in the first place. And it’s often confused with implied volatility (IV) or something else entirely. But in the end, grasping this concept doesn’t have to be complicated.

Think of vega and volatility as siblings—related, but each doing its own thing. In short, vega determines how much the dollar value of an option changes for every one-percentage-point change in volatility(vol). It’s like a translator. If vol rises, options values rise. If vol drops, options values drop. Vega can often show you by how much.

The options pricing models calculate vega. So you’re likely to find vega hanging out with delta, gamma, and the other greeks. If trading vol is part of your playbook, the critical information to understand is that vega numbers decrease as expiration nears.

For instance, long options have long, or “positive,” vega. So naturally, you want vol to increase. On the other hand, short options have short, or “negative,” vega. So you’ll want to see a drop in vol. When you combine multiple options positions, you also combine their vegas. So, long or short individual options, straddles, and strangles have the largest positive or negative vega.

In the final analysis, when you combine long and short options, you’re combining positive and negative vegas, and your position is left with the net amount. So spreads like verticals, calendars, butterflies, and iron condors can have much less vega depending on your strike selection.

The Long of It

If you’re buying premium ahead of a “numbers” release (earnings, corporate events, economic reports) and holding the position through the release, you might be trading the wrong greek.

Say you’re going into earnings. And because you think your stock will get a nice bump, you buy a short-term option. Tread with caution—this could be triple jeopardy. If you don’t get that pop, you could lose 100% of your premium. Ok, maybe not 100%. But losing almost all of it can sure feel like losing all of it. If you get a lukewarm pop, maybe you lose 90%. If you get the big pop you were looking for, you could still lose 50%.

What gives? You were likely right in your analysis, but still lost out. That’s known as a vol “crush.” Before a number comes out, vol can get pumped up based on an expectation the stock might move (see Figure 1). After the number comes out—whether the move happens or not—vol gets sucked out of the option, especially short-term options. 

When you look for a big move on earnings, it’s typically more of a gamma play, not vega. You can play vega by buying straddles, for example, or other high-vega strategies ahead of numbers, because long vega could profit if vol moves higher. That’s what traders might typically think heading into the earnings release date. But you might consider getting out before the numbers are released to avoid a vol crush that could arrive with an earnings report.

One quick aside: Another benefit of trading straddles is that heading into the release, no one knows where the stock will go. So delta and stock-direction risks are neutralized at the start of the trade.

Now, keep in mind that although IV maybe rising, which could drive a profit from long vega, negative theta may also be working against you. The straddle you have on might also acquire a delta from the gamma and stock movement combo, which could work for or against you.

The Short of It

Strategies designed to profit from increasing vol include long-vega trades like long straddles. But you can also use short-vega strategies in order to play a predicted drop in inflated vol situations, such as a vol crush after an earnings release.

If long straddle vega works when vol is rising, shouldn’t the negative vega from a short straddle work when vol drops? On one hand, it should. But a short straddle may bring undefined risk potential. For example, let’s say earnings come out and vol crumbles as the stock moves big in either direction. You’ll likely profit from your trade’s short vega, but you could end up being short a 100-delta option, which could cost you. It’s like you’re trading synthetic stock at that point—not what you want if you’re trading vega.

Some other spreads have defined risk, and they can still profit from a collapse in vol: short verticals, long butterflies, short iron condors, and short iron butterflies, to name a few. Unlike straddles (or single options), these spreads combine options with positive and negative vega, which you might think will cancel out the vega. But the net vega depends on your strike choices.

How’s that? Keep in mind that different strikes have different amounts of vega. At-the-money (ATM) options have the highest. Vega tapers off toward zero as the option goes out of the money (OTM). This difference in vega levels means spreads with strikes that are further apart can have a higher net vega. Spreads with strikes closer together will have smaller net-vega values.

One strategy for playing a volatility collapse is with a short iron butterfly. But note the difference strike selection makes between two iron butterflies using the theoretical options prices in Table 1.

The 215-220-225 short iron butterfly is short the 220 straddle for a credit of $15.85 ($7.85 credit + $8 credit) and long the 215-225 strangle for a debit of $12 ($6.40 debit +$5.60 debit). This nets a combined credit of $3.85 ($15.85 – $12), less transaction costs. Sounds like a big, juicy credit on a trade with a maximum value of $5. But the vega for this trade is only $0.02. You calculate this by taking the short $0.44 of vega for the straddle ($0.22 + $0.22) and netting it with the strangle vega of $0.42 ($0.21 +$0.21). (So, it’s not really a vega trade.)

Moving on, if you spread the strikes apart by selecting the 200-240 strangle as the long options for a net debit of $3.85 ($2.45 + $1.40 plus transaction costs), the credit for the iron butterfly jumps to $12 for a trade that can be worth $20. Yet, now the vega for the further OTM strangle drops to $0.30 ($0.15 + $0.15). This brings the vega for the 200-220-240 iron butterfly to $0.14 ($0.44 – $0.30).

By widening out the strikes, the vega exposure of the 200-220-240 iron butterfly is seven times the vega exposure of the 215-220-225 iron butterfly. Of course, these trades have different net risks, break-even points, and more. If this strategy doesn’t fit the bill, possibly consider something like the 200-210-230-240 iron condor, or any combination thereof. But consider whether your strategy is designed to profit from a change in vol.

In the final analysis, don’t let vega become an overlooked or confused greek in your trades. It’s a great tool for understanding your exposure to vol. And when you think vol changes are on the horizon, vega can help you craft a strategy designed to tackle the situation.