Question

If an investor thinks that price will increase, but thinks that volatility will decrease, what kind of
position should he take? _________________ Explain your answer, and include a profit diagram.

Answer 1

The investor should take a short put position. If the price of the underlying increases, then the price of the put option decreases. The decrease in volatility also contributes to the drop in the price of the option. So, the short put position results in a profit and the seller of the option can buy the put option back at a lower price to close the position or keep it until expiry to enjoy the full premium.  

Example: Suppose the underlying price is $100 and the put option for the strike price $90 is selling for $4. The seller of this option receives $4. And, when the price of the underlying increase and the volatility decreases the price of this put option drops to let's say $2. At this point, the option seller can buy back the put option to close the position for a profit of (4-2) = $2.

answered by: anonymous