Vega and implied volatility

Vega tells you how much an option’s price changes when implied volatility moves by one point, say from 25% to 26%.

Implied volatility, or IV, is the market’s guess at how much the stock will swing over the next year. It is written as a percentage of the stock price. Nobody announces it. It is worked backwards from the prices traders are paying for options, which is why it is called implied.

Our $100 call is priced at 25% IV. That means the market expects the stock to stay within about $7.17 of $100 over the next 30 days, about two times in three. At that IV the call costs $3.02. At 26% it costs $3.14. The difference is vega: 0.114, or about $11 per contract for each point.

Why bigger swings cost more

Think of house insurance just before a storm. The house hasn’t changed, but the chance of a large claim has, so the price goes up. Options work the same way. When traders expect big moves, every option gets more expensive.

The reason is that an option’s payoff is lopsided. If you buy the call, the most you can lose is what you paid. If the stock jumps, your gain has no fixed limit. Wider swings make a big payout more likely without making the worst case any worse. So the call is worth more when the market expects the stock to move a lot.

Our call is worth $1.88 at 15% IV and $4.73 at 40%. Same stock, same strike, same date. Only the expected size of the swings changed.

Where vega is largest

Vega is largest for options near the strike with plenty of time left. More time means more room for swings to add up, so a change in IV matters more.

At the money, vega is 0.055 with 7 days left, 0.196 with 90 days left and 0.383 with a full year. Far from the strike it shrinks. With the stock at $85 and 30 days left, vega is just 0.009, because a small change in expected swings barely changes the odds of reaching $100.

IV crush after earnings

IV usually climbs in the days before a company reports earnings. Nobody knows the results yet, so traders pay up for protection and for a shot at the big move. The moment the news is out, that uncertainty is gone and IV drops, often by half overnight. Traders call this IV crush.

Here is a worked case. The stock is at $100 the day before earnings. You buy the $100 call with 7 days left at 60% IV and pay $3.35, or $335 a contract. That IV says the market expects a move of about $8.31 by expiry.

The next morning IV is back to 25%. If the stock hasn’t moved, the call is worth $1.31. You have lost 61% of what you paid in one night. Only $0.25 of that loss was one day of time decay. The other $1.79 was the drop in IV.

To break even, the stock has to open at $102.98 or higher. You needed the stock to go up and by enough to make up for the crush. Drag the stock price in the chart below to see where you land.

Before buying options ahead of news, compare the IV with its usual level for that stock. If it is already high, the big move you expect may be priced in.