Vega

A unique risk involved in holding an option portfolio results from a jump or drop in the level of implied volatility. Implied volatility is generally expressed as a percentage that is ideally related to the expected value of the annualized standard deviation of price fluctuations that will be observed in the underlying instrument’s price over some future time period. As the name suggests, implied volatility was originally the pricing model result that was “implied” by the market’s pricing of options on an exchange based on supply and demand effects. Nevertheless, in the OTC currency option market, this relationship has reversed itself and implied volatility has instead become the traded quantity used as an essential input for determining the prices of forex options.

The sensitivity of an option’s price to movements in implied volatility is known as the option’s Vega risk. This Vega risk is typically assessed by determining what effect on an option’s value a 1% move in implied volatility would have as follows:

Vega = Change in Option Premium/ 1% Change in Implied Volatility

A positive Vega position will result in profits from an increase in volatility and is usually established by purchasing options. Therefore, when managing a portfolio of options, a trader wishing to create a positive Vega position needs to populate their portfolio with bought options. They also need to keep in mind that the portfolio’s Vega will be dominated by those options that are close to the money and have significant time to expiry remaining since such options have higher Vegas than do relatively away from the money and shorter-dated options.

Furthermore, since all “vanilla” or normal European and American-style options rise in value as implied volatility increases, a long vanilla option position will benefit from an increase in volatility and so will have a positive Vega, while a short vanilla option position will lose money from a volatility rise and so will have a negative Vega. Interestingly, this direct relationship between volatility and price does not always hold true with exotic options. For instance, knock-out options have a greater chance of being extinguished by the underlying rate hitting their trigger level if price fluctuations increase, so their value can decrease with rising implied volatility levels, resulting in a negative Vega.

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