Vega

Volatility is the expected degree of fluctuation in the spot rate. The most serious losses which occur in option portfolios are often the result of jumps in volatility.  The derivative of the option price with respect to volatility is called the vega. A positive vega position will result in profits from an increase in volatility. To create a positive vega, a trader needs to dominate the portfolio with bought options, bearing in mind that the vega will be dominated by those options that are close to the money and have significant time to expiry remaining.

VEGA = Change in Premium

Change in Volatility

As all options rise in value with increases in volatility, a long position will benefit from an increase in volatility whilst a short position will lose money (Again this is riot always true in the case of exotic options).

The volatility is normally annualised and expressed as a percentage. This volatility can be estimated from a sample of historical data for the asset price- The problem with this is to decide how many days to go back, and there is no fixed answer to this. The historical estimate assumes, of course, that the past is a good guide to the future.

In an exchange traded market, one can readily deduce the market's view of volatility by taking the market value of an option and all the other inputs except volatility, and 'backing out' the volatility which would be needed in the formula to make the market price equal the fair value. This is called the implied volatility. The problem with this can be that options at different strikes with the same maturity may have different implied volatilities. This implied volatility is basically what the market trades in fact, and many markets are even quoted in volatility terms. Volatility becomes a traded entity in its own right and is the essence of modern option markets.

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