Question

Discuss the impact of volatility on the premiums of calls and puts.

Answer 1

Volatility is the change in the underlying prices of the security due to changes in market conditions. An increase in the volatility of the security's price increases the call and put premiums. The reason being an increase in the volatility will increase the probability that the option will be deeper at expiration. When there is higher volatility there is higher upside/downside risk. In case of a downside risk, the buyer will not exercise the call option and forego the premium. If there is a upside risk , the call option will be exercised by the buyer to cash in profits. Similar is with put options as well.