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Journal of Undergraduate Research

Keywords

financial market, volatility, option trading

College

Marriott School of Management

Department

Management

Abstract

An in-depth understanding of financial-markets volatility and how it relates to option prices is of prime importance for any options professional. Volatility is a key variable of the various option-pricing models, the Black-Scholes model being the most widely applied, that have evolved over the past twenty years. Volatility can be thought of as the standard deviation of return for the prices of the asset underlying an options contract. Generally speaking, volatility is positively correlated with options prices. This is fairly intuitive, for a long position in an option is a position with limited downside risk and unlimited upside potential. If volatility is high, a trader is more likely to receive a very high return than if the volatility is low. In both cases, the trader’s downside risk is limited to the price initially paid (the premium) to purchase the option. Because the potential payoffs are greater, the premium paid for an option on an underlying that is highly volatile will be greater than the premium paid for an option on an underlying that has a lower volatility.

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