Anyone knows the answers to these 2 qns? 1. For three-month options on the FTSE 100 index, which of the following is likely to have the highest implied volatility? A)A slightly out-of-the-money call B)A slightly out-of-the-money put C)A deep out-of-the-money call D)A deep out-of-the-money put 2.Which position is similar to a long futures position? A)a call option B)a forward starting call option C)buy an ATM call and sell an ATM put D)sell an ATM call and buy an ATM put

- an option slightly out of the money has higher implied volatility compared to a deep out of the money option eliminating C) and D). I believe a call option has higher volatility then a put since a call’s loses are theoretically unlimited… so I’d go with (A) 2) A long call and short put at the money will simulate the same returns as a long futures position. so ©

wow char-lee, i believe you are not a lvl 1 candidate? or either i didnt read my materials thoroughly on derivatives…lol

I’d go with A and C too.

Sorry Char-Lee but your answer to #1 is incorrect. The correct answer is D) A deep out-of-the-money put. Here’s why: Investors are willing to pay a premium for insurance against large adverse moves. The only one of the option pricing inputs that can change to reflect this is volatility, hence higher vol for deep out of the money puts. Another way to look at this is that market participants expect a relatively higher probability for large downside moves. Higher expectations of movement (downside in the case of a put) = higher implied volatility.

Yeah, but guessing at the vol skew doesn’t seem too fair to me. Good explanation though, jack. C) is good for #2.

In my case, i chose either A or B for qn 1 as it’s a 3mth options which is a relatively short term period so i don’t expect it to be highly volatile. Any views on this? I agree with the ans for qn 2 though. Btw, i got this qn while applying for a position in a reputable financial institution.

No chance it’s A or B for #1. implied vol is always lowest for ATM options and increases in both directions from there (it’s called the “vol smile”). There are gajillions of academic papers addressing why the vol smile exists and lots of models for it. Basically nearly any violation of the B-S conditions gives you some kind of vol smile.

So i guess this qn is not in the lvl 1 syllabus?

I don’t know but it’s a pretty fundamental thing about options. jack gave some nice explanations of why this exists, but another way to think about it is that B-S says nothing about vol smiles - there should be one implied vol for all option strikes. But B-S assumes normality (the really cool thing about all that risk neutral valuation is that there’s this impossible to solve stochastic differential equation and with a wave of the hand it becomes some ordinary undergraduate calculus problem using the normal distribution). Everyone knows that all securities have fatter tails than normality and you need a vol smile to account for that.

Interesting stuff about the first question. I don’t have any experience w/ implied volatility beyond the CFA Program, which at LII basically just defines it as an alternative to historical volatility and describes the process of its calculation, showing an example. There’s neither discussion of how implied volatility can be inferred from an option’s moneyness nor mention of the volatility smile. I don’t know of any options pricing material at LI (thankfully!). My understanding is that you’re required to understand their mechanics, like defining their properties (e.g. an exercise price) and determine their values under certain circumstances. However, the second question looks like fair game at LI to me. I recall a question of this type on my LI exam in '06

1st one is not really covered in L1… but i’d guessed either B or D, with D more being more probable. 2nd q is fair; i think theres a term for long call short put combination… .i forgot what tho…

mystically Wrote: ------------------------------------------------------- > wow char-lee, i believe you are not a lvl 1 > candidate? > or either i didnt read my materials thoroughly on > derivatives…lol Agreed- I read his questions and said, “awwww sh***t” to myself. I guess I’m starting to study hardcore this weekend.

for the record I did not answer the 1st question correctly… I did not recall the implied volatility topic in the Level I material and made an educated guess (obviously not educated enough). question 2 is a common Level I question and is a fundamental concept in options, so this must be understood. to be honest I still don’t understand Jackoliver and Joey’s responses, intuitively I feel like price volatility will be higher when an option is near its strike… perhaps there is a difference in price volatility and implied volatility (i would presume there is, hence the correct answer vs my intuition) if anyone (joey too) would care to add more regarding question 1, great, otherwise I’ll wait to read the material to grasp this topic.

Char-Lee Wrote: ------------------------------------------------------- > to be honest I still don’t understand Jackoliver > and Joey’s responses, intuitively I feel like > price volatility will be higher when an option is > near its strike… perhaps there is a difference > in price volatility and implied volatility (i Implied vol is the vol you would plug into a B-S calculator to achieve the market observed price of the option. Say you’re a dealer writing options. You need to cover your risks and balance out supply/demand to determine the price you’ll charge. OTM options are priced higher (i.e., their implied vol is higher) for a couple of reasons: 1. supply/demand: more people generally want to buy than to sell downside protection, so OTM puts are expensive. (This can lead to a one-sided smile: the vol “smirk”.) 2. event risk: information traders will often seek to monetize their information advantage with OTM options. Assuming they’re right, the option writer takes the loss. So the dealer will charge a premium for OTM options. 3. Liquidity: ATMs trade more often, so margins are thinner. caveat: I don’t do this for a living, just filling in whole the big guns are out for coffee or getting married

well done Darien, that all makes complete sense to me esspecially after the clarification of implied variablity and its use as a Black-Scholes input/output. i won’t soon forget the volatility smile. thank you.