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Vega Neutral What it is How it Works Example

Vega Neutral What it is How it Works Example

Vega Neutral: What it is, How it Works, Example

What Is Vega Neutral?

Vega neutral is a method of managing risk in options trading by establishing a hedge against implied volatility.

Vega is one of the options Greeks along with delta, gamma, rho, and theta. It represents the sensitivity of an option’s price to volatility. Traders use a vega neutral strategy when they believe volatility poses a risk to profits.

Key Takeaways

  • Vega neutral is a risk management method in options trading that establishes a hedge against implied volatility.
  • Options traders use vega neutral when volatility poses a risk to profits.
  • Vega represents the sensitivity of an option’s price to volatility, but it is not volatility itself.
  • Vega is one of the "options Greeks," along with delta, gamma, rho, and theta.

How Vega Neutral Works

Vega neutral is less popular than neutral positions for other Greeks. Vega measures how a 1% change in implied volatility affects the price of an option. A vega neutral position removes the sensitivity to volatility from calculations. Being vega neutral means a position does not gain or lose money when implied volatility changes.

Building a Vega Neutral Portfolio

The vega of a single position is displayed on major trading platforms. To calculate the vega of an options portfolio, sum up the vegas of all positions and subtract the vega on short positions from the vega on long positions (weighted by lots). In a vega neutral portfolio, the total vega of all positions is zero.

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Example of Vega Neutral

For example, if an options trader has 100 lots of $100 strike calls with a vega of $10 each, they will short 200 lots of $110 strike calls with a vega of $5 to eliminate $1,000 worth of vega.

However, this oversimplifies the process and doesn’t account for different expirations or other complexities. Achieving true vega neutrality is difficult when options have different expiry dates because implied volatility does not move by the same amount in options with different terms.

The implied volatility term structure shows that options generally have fluctuating IV depending on the expiration month. To address the expiration issue, a time-weighted vega can be used, assuming that IV is mainly influenced by time to expiry.

If a trader wants to create a vega neutral position with options on different underlying products, they must be confident in the degree of correlation between the two products’ IV.

Vega neutral strategies usually aim to profit from the bid-ask spread in implied volatility or the skew between the implied volatility in puts and calls. However, vega neutral is often used in combination with other Greeks, such as delta neutral/vega neutral trades or long gamma/vega neutral trades.

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