The level of future price movement the market is pricing into an option, inferred from its premium. It rises when uncertainty increases, which is why protection costs the most at precisely the moment investors most want it, and it can move an option premium substantially even when the underlying price has not changed.
Practice questions using Implied Volatility
Original questions written against the published FINRA and NASAA exam content outlines — not actual exam questions. Every choice is explained.
A client holds a long call option and the underlying stock trades at essentially the same price for several weeks. Over that period the premium on his option will generally
A.decline, because time value erodes as the expiration date draws nearer.Correct. Time is an input in its own right, and it is consumed whether or not the stock moves.
B.remain unchanged, since the price of the underlying stock has not moved.Wrong. The premium has two components, and the passage of time consumes one of them regardless.
C.rise, because a longer record of stability makes the option safer to hold.Wrong. Stability reduces the likelihood of the very move the option needs in order to pay.
D.decline, but only where the option is currently in the money.Wrong. An out-of-the-money option is nothing but time value, so it decays fastest of all.
Why: An option is a wasting asset because one of the two components of its price is the time remaining before expiration. Holding the underlying still, the passage of time removes optionality without replacing it with anything, so the premium erodes and the erosion accelerates as expiration approaches. This is why a long option position needs the underlying to move, and to move soon enough, before it can be profitable. A rise in implied volatility could offset the decay for a time, but nothing in a period of price stability supplies one.
A client asks to buy protective puts after a sharp market decline is already under way. Compared with buying the same cover during a calm period, he should expect
A.a lower premium, on the basis that the decline has already taken place.Wrong. An option is priced on the moves still to come, not on those already behind it.
B.the same premium, since the strike and the expiration date determine the price.Wrong. Those set the terms of the contract, and volatility is what puts a price on them.
C.a higher premium, because elevated implied volatility raises option prices.Correct. Protection costs most exactly when the market expects the largest further moves.
D.a higher premium for calls only, since puts cheapen in a falling market.Wrong. Put prices rise in a decline, both from the move itself and from the volatility increase.
Why: Option prices rise with implied volatility, which itself rises when markets fall and uncertainty increases, so the cost of protection is highest at precisely the moment clients most want it. The buyer is paying more for the same strike and the same expiration simply because the market now expects larger moves. This is the practical reason a hedging decision belongs in the plan before it is needed rather than in the middle of a decline. Buying the cover in calm conditions costs less, but it also means paying for protection in the many periods when it turns out not to be needed.
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