Implied Volatility and Vega: The Price of Movement

Implied volatility is the market's current estimate of how much the underlying will move, priced into the option.

Fire insurance on an igloo is cheap. Fire insurance on a wooden house on a hot dry day with a barbecue going is expensive. Same cover, same payout, same year. The price is different because the chance of a big event changed. When people say "vol is up", the barbecue got lit: options got more expensive without the underlying doing anything.

• Extrinsic. The part of an option's price above what it would pay if you used it right now. It is what you pay for time and for possible movement, and it is the part vol inflates.
• Delta and the hedge. Delta is how much an option's price moves per 1 point in the underlying. The dealer (the market maker who took the other side) holds futures sized by delta so price moves do not hurt them. That position is the hedge.
• Vega. How much an option's price moves when implied vol changes by one point. Biggest at the money and with more time left. Not a bet on direction. It only changes what the option is worth as the vol number moves.
• Long vega, short vega. Own the option and you gain when vol rises. Sell it and you lose when vol rises.
• Vanna. How much delta changes when implied vol changes. It is the link between vol and the hedge.

Fact marks Black-Scholes maths and hedging arithmetic. Naive model marks a story about what dealers or price will do: useful, not a fact.

FactThe teal bell is vega at every underlying price for a 100 strike. It is tallest at the money, where the extrinsic is fattest, and fades to nearly nothing far from the strike, where there is barely any extrinsic for vol to inflate. More days left means more vega.

FactWhen implied vol moves, every option on the board reprices without a single trade in the underlying. If you watch a positioning screen (a chart of how many options sit at each strike), you will see its bars rescale while price sits still. Nothing about the positions changed. The price of risk did.

FactImplied vol is quoted per year and scaled by the square root of time. One standard deviation of movement over a period is roughly price x implied vol x the square root of the time, in years. On the model's distribution about two thirds of outcomes land inside one of those, and about 95% inside two. Real markets have fatter tails than the model.

FactRaise implied vol and every delta away from the strike drifts toward the middle: calls toward 0.50, puts toward -0.50. Lower it and deltas snap to the extremes: 0 or 1 for calls, 0 or -1 for puts. Raising vol is like handing the option more time. Changed deltas mean hedges that are now wrong and must be corrected. Customers bought 100 calls here (example), so a dealer is short them and holds a hedge. Move vol and watch the forced trade, with price standing still.

When the whole options board rescales on a quiet tape, I do not assume I missed a flood of new positions. That is vega: the price of risk changed.

FactWhen price moves with nothing on the news feed, a jump in implied vol is one honest answer. It changes every delta, the hedges are suddenly wrong, and correcting them is a real ES or NQ order with no price move that caused it.

Naive modelI read the direction of vol, not its level: spot VIX or VIX1D against the previous close. VIX at 17 and rising is a rising-vol day. VIX at 24 and falling is a falling-vol day. On falling-vol days moves tend to end at strikes where options were bought. On rising-vol days they tend to run through them. It is context for my own trading, never a signal on its own.

Knowing what vol does to the board is one piece of reading the market. The Mentorship is where you put the whole process together.