Volatility, Vega and How Options Are Priced

Option prices are fundamentally about uncertainty. The more uncertain the market is about where an underlying will go, the higher the premium is for both calls and puts—because a bigger move is more likely. Volatility is a quantitative measure of that uncertainty.

Historical volatility is calculated from past price data—it tells you how much the underlying has bounced around over the past 20, 30, or 60 days. But option prices respond to implied volatility, which is what the market is pricing in for the future. When you see option premiums spike even though the underlying price hasn't moved, it's because implied volatility has jumped; the market is pricing in more uncertainty for the days or weeks ahead.

Vega measures how much an option's price will change when implied volatility rises or falls by 1 percentage point. If a call option has a vega of 0.08, a 1-point rise in implied volatility will increase that option's premium by approximately 8 paise. Long options (bought calls or puts) are long volatility—you profit if volatility rises. Short options are short volatility—you profit if volatility falls or stays stable.

Professional option pricing models (like Black-Scholes) estimate fair value based on the underlying price, strike price, time to expiry, interest rates, and implied volatility. In India's options markets, these models are used by market makers and large institutional traders. If the model says an option should be worth 100 rupees but the market is trading it at 95, you might have an opportunity to buy it cheap. If it's trading at 110, you might look to sell it.

• Volatility = the market's expectation of how much the underlying will bounce.
• Vega = sensitivity to changes in implied volatility.
• Option prices embed expectations about future uncertainty.
• Long options bet on volatility increasing; short options bet on it falling.