What Is Kappa?

What Is Kappa?

Let me explain kappa directly to you: it's the measurement of how sensitive an option contract's price is to changes in the volatility of the underlying asset. Volatility here includes recent price changes, historical ones, and expected future moves. For something like an option, volatility captures both the amount and the speed of price ups and downs.

Key Takeaways

You should know that kappa measures an option contract's price sensitivity to volatility changes in the underlying asset. It's also called vega and is one of the four primary Greek risk measures, named after Greek letters. Kappa calculates the price change for a 1% shift in the implied volatility of the asset. Together with theta, gamma, and delta, these measures show how options react to time decay, volatility changes, and underlying price movements.

Understanding Kappa

Kappa, which you might hear called vega, stands as one of the four main Greek risk measures, denoted by Greek letters—though vega isn't actually Greek; the 'v' is for volatility, like 't' in theta for time. Option prices get influenced by various factors, and these Greeks help measure them when you're analyzing options. This group—kappa, theta, gamma, delta—reveals an option's sensitivity to time-value decay, implied volatility shifts, and underlying security price changes.

Here's how kappa works: it measures the risk by figuring out how much an option's price changes with a 1% change in the implied volatility of the underlying asset. You can hedge against some of that volatility by setting up a neutral position.

Kappa is higher when the option's expiration is further out. It drops as expiration nears because the option gets more sensitive to the asset's price volatility close to expiry—options expiring right away even have negative kappa. That's due to future-expiring options carrying higher premiums than immediate ones.

When the underlying asset sees big price swings indicating volatility, kappa adjusts. It falls nearer to expiration and measures price change per percentage point in implied volatility. Remember, implied volatility is just a prediction—it might not match actual future volatility. We calculate it via models based on what current market prices suggest for the asset's future volatility.

You can calculate kappa for single options or for a whole portfolio, where it's called net kappa by adding up each position's kappa.

The other Greeks are delta, gamma, and theta. Delta tracks the effect of underlying asset price changes—it's the ratio of asset price change to derivative price change. Gamma measures delta's rate of change per 1-point move in the underlying price. Theta covers the price impact from time passing, known as time decay.