Effect of Implied Volatility on Option Pricing

Question

How does implied volatility affect the price of an ATM option?
 	Does this also hold for deep ITM or deep OTM options?

Accepted Answer

Higher implied volatility increases the option's premium, as it indicates a greater likelihood of the option ending in-the-money due to larger expected price swings of the underlying asset.
 	No, deep OTM options are considered as such if it's extremely unlikely for the option to end up ITM, and deep ITM options are considered as such if it's extremely likely for the option to end up ITM. Therefore, a change in the implied volatility barely makes a difference.

Elaboration
Implied volatility (IV) is a metric that reflects the market's expectations of the future volatility of the underlying asset's price. It is derived from the prices of options in the market and plays a crucial role in option pricing models, such as the Black-Scholes model.

Impact on ATM Options
For at-the-money (ATM) options, implied volatility has a significant impact on the option's price. ATM options have a strike price close to the current price of the underlying asset. Since the payoff of ATM options is highly sensitive to movements in the underlying asset's price, changes in implied volatility can lead to substantial changes in the option's value.

 	Increased Implied Volatility

 	Higher Option Premium: When implied volatility increases, the prices of ATM options typically rise. This is because higher volatility increases the probability that the option will end up in-the-money at expiration.
 	Greater Time Value: The time value component of the option's price is higher with increased implied volatility. This reflects the greater uncertainty and the higher potential for significant price movements of the underlying asset.


 	Decreased Implied Volatility

 	Lower Option Premium: Conversely, when implied volatility decreases, the prices of ATM options usually fall. Lower volatility implies a lower probability of substantial price changes, reducing the likelihood that the option will end up in-the-money.
 	Reduced Time Value: The time value component of the option's price diminishes with decreased implied volatility, reflecting less uncertainty and lower expected price movements.



Impact on ITM or OTM Options
For both ITM and OTM options, the impact of a change in the implied volatility is less compared to the impact for ATM options.

 	For ITM options, an increase or decrease in the implied volatility has less of an impact on the probability that the option ends up ITM. To understand this better, consider deep ITM options. The probability that these end up ITM is close to 100%. For that probability to change, the volatility should increase drastically.
 	Vice versa, the same goes for OTM options. For OTM options, an increase or decrease in the implied volatility has less of an impact on the probability that the option ends up ITM. Deep OTM options will most probably not end up ITM, unless the volatility increases drastically.

Title	Category	Subcategory	Difficulty	Status
Forward Skew	Derivatives Theory	Implied Volatility	Medium	Example
Higher Implied Volatility	Derivatives Theory	Implied Volatility	Easy	Unlock
Historical vs. Implied Volatility	Derivatives Theory	Implied Volatility	Easy	Unlock
Liquidity Effect	Derivatives Theory	Implied Volatility	Medium	Example
Predictive Power of Implied Volatility	Derivatives Theory	Implied Volatility	Easy	Unlock
Reverse Skew	Derivatives Theory	Implied Volatility	Medium	Unlock
Volatility Surface	Derivatives Theory	Implied Volatility	Hard	Unlock

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