Why Should Volatility Increase Option Prices?

The typical explanation lies in the fact that options present assymetric payoffs: lots to gain, little to lose (known premium) from turbulence. Bring chaos on!

Another rationale is that enhanced vol makes the competition look worse. For many (hedgers particularly) the key decision is whether to go with options or forwards. Competition can be intense. Heated. Any small change can tilt the balance in favour of one or the other.

People who love forwards do so mostly because they don´t cost premium (extra leverage). This is of course due to their payoff linearity. That is, in this case, chaos can equally bring outsized gains and outsized losses. Options prevent the latter, and that is why they cost cold hard cash.

But I will not pay if I believe that mayhem will be very tame, because in that case the nightmares from the forward would be so limited. Too small to make me worry. Too small to make me reach for my wallet and enter the option shop.

If I expect vol to be small, the option loses competitive edge, and thus value. If I expect vol to be high, options would become comparatively more attractive.

ptriana@profesor.ie.edu