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What is the Impact of Volatility on Option Prices?

Option pricing models make assumptions about the possible distribution of the prices of an option's underlying instrument in the future. The Black-Scholes Model assumes that the percentage price movements of shares follow a standard deviation, which is the likelihood of a share increasing by 20 percent is the same as the likelihood of the share falling by 20 percent. The model also assumes that there are no trends, and that the share's expected return equals zero.

Standard deviation:

10 20 30

The likelihood that the prices won't change is always the highest (top of the bell), with a standard deviation. The current price has the highest probability. The probability of larger percentage changes falls - to the same extent - on both the upside and the downside of the current price level. A higher volatility implies larger price fluctuations in percentage terms, and the possible attainment of distant prices.

note: for shares, the deviation from the forward price of the share is determined; the forward price differs from the cash price of the share by financing costs and returns.

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