What is Vega Neutral?

A surfer landed on this blog when searching for the phrase: ‘What is vega neutral?’
This is not a topic that I have discussed at Options for Rookies, and this is an opportunity to do .

Definition of Vega

In simple terms, vega let’s us know how much we should expect an option’s price to change, when the implied volatility (IV) of the option changes by 1%. Note: The term ‘1%’ refers to a change in the implied volatility from 30 to either 29 or 31.

When we sum the total vega of each of the options in a given position, vega tells us how much we can anticipate earning (or losing) when IV changes by one point

Using more ‘official’ terminology: Vega measures the sensitivity of the option premium to volatility. In other words, as the volatility environment changes, the value of an option changes.

‘Option premium’ refers to the real value of the option in the marketplace and the term ‘volatility’ in this context, refers to the implied volatility of the option.

Mathematically, vega is the derivative of the option value with respect to the volatility of the underlying asset.

Vega Neutral

Most individual investors and traders tend to trade with a market bias. They are bullish or bearish; they believe that the market will be quiet (less volatile) or exciting (volatile). They construct positions that earn money when their bias becomes reality.

Most professional option traders prefer to own positions with minimal risk, they build positions that are neutral in as many respects as possible.

Delta neutral positions are neither bullish nor bearish.
Gamma neutral positions remain delta neutral as the market rises or falls.
Theta neutral positions neither make nor lose money as time passes.

A vega neutral position has a total vega near zero and offers a hedge against a change in the implied volatility of the underlying. The trader who has a market bias that she wants to play, but does not want to be exposed to a loss if the implied volatility changes, makes a trade that is vega neutral.

It is important to understand that we option traders have the ability to control risk, and being vega-neutral is one of those ways used by more sophisticated traders.

Personal note: The positions that I trade are seldom, if ever, vega neutral.

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One Response to What is Vega Neutral?

  1. Lies 01/11/2014 at 11:11 AM #

    I consider to trade non-directional but with a pure volatility trade.
    Sell 30 delta puts and calls and trade an appropriate number of futures on a weekly basis (to make it delta neutral).
    By doing this i hope to capture the volatility premium (in index options).

    Is this something you have experience with? If not, why haven’t you never considered doing this?
    Transaction costs are low and the software from the brokers make it very easy.

    Hello Lies,

    Yes, I have experience with this type of trade, but have not used this strategy in at least 30 years.

    Low trading costs and good software are great features. However, I am not willing to be naked short index options.

    Please understand that when a trader is short calls and puts and hedges any delta with futures, that trader is still exposed to a gigantic loss on a gap opening. So, unlikely as it is to see such an event, I am not willing to take any chances in that regard.

    I prefer to ‘waste’ my money by owning a lower-delta call and put as a way of limiting losses.

    NOTE: There is no doubt that your method earns a ton more money than the more conservative approach when the strategy is working well. I am unwilling to learn just how large the loss can be if we ever have another Oct 1987.

    I am merely being cautious. That does not mean you have to be cautious. 🙂