Options Trading Options Pricing and Valuation 2 — Questions and Answers
Question 1: Implied volatility (IV) is best described as:
- The market's expectation of future volatility priced into an option (Correct answer)
- The historical volatility of the underlying over the past year
- The standard deviation of actual past returns
- The rate at which an option's price changes with delta
Correct answer: The market's expectation of future volatility priced into an option
Implied volatility reflects the market's consensus expectation of how much the underlying will move in the future, derived by back-solving the Black-Scholes formula.
Question 2: What happens to a call option's price when the underlying stock price increases, all else equal?
- It increases (Correct answer)
- It decreases
- It stays the same
- It decreases by the same amount
Correct answer: It increases
A call option's price increases when the underlying stock price rises because the option becomes more valuable or deeper in the money.
Question 3: What is a 'volatility smile' in options markets?
- A pattern where OTM and ITM options have higher IV than ATM options (Correct answer)
- A strategy using multiple volatility-based positions
- The shape of a profit/loss diagram for a long straddle
- A measure of skewness in the underlying asset
Correct answer: A pattern where OTM and ITM options have higher IV than ATM options
A volatility smile occurs when out-of-the-money and in-the-money options have higher implied volatility than at-the-money options, forming a U-shaped curve.
Question 4: Which factor causes a put option's value to increase?
- A decrease in the underlying stock price (Correct answer)
- An increase in the underlying stock price
- A decrease in time to expiration
- A decrease in implied volatility
Correct answer: A decrease in the underlying stock price
Put options increase in value when the underlying stock price decreases, as the right to sell at a fixed strike price becomes more valuable.
Question 5: The binomial options pricing model is most useful for pricing:
- American-style options that can be exercised early (Correct answer)
- European-style options only
- Options with no time value
- Options on non-dividend-paying stocks exclusively
Correct answer: American-style options that can be exercised early
The binomial model handles American-style options well because it can evaluate the option's value at each node, allowing for early exercise decisions.
Question 6: What does 'IV rank' measure in options trading?
- Where current IV sits relative to its 52-week range (Correct answer)
- The absolute level of implied volatility
- The rank of options by trading volume
- How delta compares across different strikes
Correct answer: Where current IV sits relative to its 52-week range
IV Rank (IVR) measures where the current implied volatility sits within its 52-week high-low range, expressed as a percentage from 0 to 100.
Options Trading Options Pricing and Valuation 2
Implied volatility (IV) is best described as: