If you are holding a long position in a call option, would you benefit from a mo
ID: 2810832 • Letter: I
Question
If you are holding a long position in a call option, would you benefit from a more or less volatile market? What about a put option? Briefly explain.
According finance theory, an increase in risk will result in a lower price. If we are talking about the volatility of the option value, then the price of the option should go down. However, here we are not talking about the volatility of the option value, we talking about the volatility of the underlying asset upon which the option derives its value.
Similarly, a $2 million house located on the hill top where the risk of land slide land is high will be selling at a lower price (ceteris paribus) whereas the insurance premium on that house will be higher as compared to similar house located far away from the potential land slide area.
Explanation / Answer
a long position in a call option is favourable to the investor, in case the prices of the stock goes up. The option holder pays premium on the option, if the markets are volatile then the option holder will benefit from the position. A very small increase in stock prices will not make the call option very profitable to the option holder.Same is the case for a put option, the only difference is that the put holders benefit from the fall in the stock prices.
since, we discussed the more volatile the stock prices are, the more valuable is the option. The option holder has to recover the premium paid plus derive a profit from the option. The option derives it's value from the value fo the underlying asset which is the stock. The more volatile the prices of the stock , the more valuable is the option.
the house located the top of the hill, it's accesibility is an issue and it is prone to landslides. The desirability of the people living there is low. The risks and dangers are high as a result of which the prices of the properties are low and the risks make the insurance premiums on the house more. As there is greater certainty of an accident occuring.
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