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NISM Certifications · NISM-Series-VIII: Equity Derivatives · Introduction to Options

Which statement about the effect of an increase in volatility of the underlying on option premiums is correct?

Premiums of both calls and puts tend to rise when volatility increases. Greater volatility raises the probability of large price moves in the buyer's favour, while the buyer's loss remains limited to the premium paid, so both option types become more valuable.

  1. APremiums of both calls and puts tend to riseCorrect
  2. BCall premiums rise and put premiums fall
  3. CPremiums of both calls and puts tend to fall
  4. DOnly deep out-of-the-money options are affected

Explanation

Higher volatility raises the chance of large favourable price moves, while the downside for a buyer is limited to the premium. This increases the value of both calls and puts. The option's payoff is asymmetric, so volatility helps both types.

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