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Option Basics – What Vega Means to the Covered Write

Vega measures the sensitivity of the price of an option to changes in volatility. Vega is the estimate of the change in theoretical value of an option for the 1% increase in implied volatility. A higher volatility means higher option prices while a lower volatility means lower option prices. Vega is the measure of changing volatility on option prices. A higher volatility means an expected higher price swings in the stock.

An increase in volatility will increase the price of options on the stock while a decrease in volatility will cause all options on the stock to decrease. The vega of a long call or put option is always positive while the short calls and puts are negative. At-the-money (ATM) options have the highest vega so they are most sensitive to volatility changes. The further an option goes ITM or OTM, the smaller its vega will be. As volatility decreases for ITM and OTM options, vega is unchanged for ATM options. Vega decreases when time elapses similar to call premium decay. This causes vega to be higher for long dated options than short dated options. Of course, LEAPs have a high vega so an increase in volatility will raise the time value of the option.

For example, a stock that is trading at $35 with a high volatility of .75 with a vega of 30%. The stock option will lose $.30 for every 1% decrease in volatility and gain $.30 for every 1% increase in volatility. If volatility decreases by 20 points, then the stock option will decrease by $6.00. This suggests that you do not want to buy any call or put with a high volatility. Vega can cause option prices to change even if the stock price does not change.

Typically, I do not use vega in covered call trades as I tend to only sell options on stocks below 40% volatility and usually in the current option month. However, vega is important if you use LEAPs as a replacement for stock in a covered call trade.

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