Vega is one of the "Greeks," which are a set of sensitivity measures that help traders understand how options prices are affected by changes in various underlying factors. Vega specifically measures the sensitivity of an option's price to changes in the volatility of the underlying asset.

So, what’s the relationship between volatility and option premium. Let’s get back to the drawing board and understand what high volatility means?

As stock price movement cannot be pre-conceived, the price path taken by the stock could be filled with unpredictable and sometimes sharp moves, also known as price turbulence. A measure of this turbulence/unpredictability is what defines volatility. The erratic moves as discussed, can occur on either side of the current market price, either higher or lower. So, the wider and wilder the fluctuations, the higher, the volatility measure.

 This is what defines high volatility. Now, high volatility would actually push a lot of stock portfolio investors to buy options to hedge their risks. At the same time, high volatility is a deterrent for option sellers to immediately sell in the market, even if they do, they would desire higher option premiums to account for that high volatility.

Therefore, the new demand supply dynamics would push up the option premia.

So, much for volatility and option premium relationship.

Vega, the sensitivity measure, first order Greek, has maximum magnitude on ATM strikes and is lower as strikes are away from the current underlying price of Nifty/BankNifty/FinNifty or F&O stocks.

The magnitude of vega is proportional to the time to expiration of options, the options with longer time to expiration generally have a higher vega, with the highest at ATM strike.

We notice in the chart ahead that as DTE increase, vega increases. The use of Quantsapp option calculator is done to understand the variability of vega across different strike prices and also across different expiries.

Nifty option ATM strike = 17750

Date of computation = 7 Feb 2023

Implied volatility assumed at 20%.

We notice, ATM vega drop to 5 from 15 as expiry changes from 23 Feb 2023 to 7 Feb 2023, implying as expiry nears vega of an option actually drops.

Vega only measures sensitivity of option premium to changes in the volatility of the underlying asset keeping other factors constant. Do we agree that to make informed decisions, the dynamics of vega, which shall be governed by 2nd order greeks need to be studied. (We would be looking at some of them later!)

Understanding vega and other related option greeks, can help traders make more informed decisions about their options trading strategies.          

Implied volatility is calculated from the market price of options, using the Black Scholes option pricing model. This is the volatility input, which causes the option pricing model to give out the ideal price of the option, which matches the market price of the options. It is different from vega.

Vega measures the impact of volatility on option premium. It measures the ratio of change in option premium to the change in volatility of the underlying. Vega is the first order Greek.

Vega value depends on option position, for option buyers (i.e. call or put) increasing volatility pushes up option premia, implying positive vega option greeks. Hence, short option positions or sell option positions possess a negative option vega.

With a negative vega, a portfolio of options will be profitable when volatility drops.

When Vega is high, it implies that a particular option with high vega means for a small change in volatility, the option premium change would be high. This can be seen as a form of insurance against increased volatility, as the option buyer will benefit from a large increase in the option price if volatility increases.

A short Vega strategy is a trading strategy that involves taking a short position in an option or option portfolio with a high option Vega value. The objective of this strategy is to profit from a decrease in the volatility of the underlying asset.

It's worth noting that short Vega strategies can be risky, as the trader is exposed to unlimited potential losses if volatility increases instead of decreases.