The Effect of Stock Volatility
One of the basic principles of
investor behavior is that individuals prefer less risk to more. For holders of
stocks, higher risk means lower value. But higher risk in a stock translates into greater value for a call option on
it. This is because greater volatility increases the gains on the call
if the stock price increases, because the stock price can exceed the exercise
price by a larger amount. On the other hand, greater volatility means that if the stock price goes down, it can be
much lower than the exercise price. To a call holder, however, this does not
matter because the potential loss is limited, it is said to be truncated
at the
exercise price. In fact, die option holder will not care how low the stock price can go. If the possibility of
a lower stock price is accompanied by the possibility of higher stock prices, the option holder will
benefit, and the option will be priced higher when the volatility is higher.
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