Understanding Implied Volatility and Market Expectations

Easy Option Valuation Implied Volatility

In the context of option pricing, implied volatility (IV) is a critical concept that reflects the market's expectations of the future volatility of the underlying asset. IV is derived from the market price of a given option and is believed to capture the risk perception among traders. Traders and analysts often utilize IV as a gauge for market sentiment and activity.

If a stock option has a higher implied volatility, it often indicates that the market anticipates significant movement in the stock price, either up or down. Conversely, a lower implied volatility suggests that the market expects the stock price to remain relatively stable.

Consider a call option on a stock currently trading at $100 with a strike price of $105. If the call option is priced at $10 with an implied volatility of 20%, which of the following statements is true regarding the relationship between the implied volatility of the option and market expectations?

Higher implied volatility generally indicates traders expect larger price movements.

Implied volatility is inversely related to the expected direction of stock price movement.

Lower implied volatility suggests that the market expects a breakout in the stock price.

Hint

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