What is 'vega' and why does an option's price depend on volatility?

• A. Vega measures the sensitivity of option price to changes in time to maturity.
• B. Vega measures the sensitivity of option price to changes in the underlying price.
• C. Vega measures the rate of change of delta with respect to the underlying.
• D. Vega measures the sensitivity of option price to changes in implied volatility.

Answer: (D)

Vega is the sensitivity of an option’s price to changes in implied volatility. Implied volatility represents the market’s expectation of how volatile the underlying will be over the option’s life. In pricing models, higher volatility increases the range of possible future prices, raising the probability that the option finishes in the money and boosting the option’s extrinsic value. So, when implied volatility moves, the option price moves in the same direction, and vega quantifies that sensitivity—often expressed as the change in price for a 1 percentage point shift in volatility.

Vega is typically positive for all standard options, meaning higher volatility makes both calls and puts more valuable. It tends to be larger for longer-dated and near-at-the-money options, since there’s more time and probability for volatility to impact outcomes.

To place it in context with the other greeks: theta measures sensitivity to time decay, delta measures sensitivity to changes in the underlying price, and gamma measures the rate of change of delta as the underlying moves. Vega specifically isolates how the option’s value responds to shifts in volatility.