How does volatility impact the price of an option?

Volatility plays a crucial role in determining the price of an option. The rationale behind this lies in the fundamental nature of options, which are derivatives that derive their value from an underlying asset, typically a stock. When volatility increases, the potential for the underlying asset's price to fluctuate significantly rises. This increased uncertainty creates a higher chance for the option to end up in-the-money (meaning the option holder can exercise it profitably) before expiration.

Higher volatility implies a greater likelihood of substantial price movements, which enhances the expected value of the option. Consequently, with the potential for larger swings in the underlying asset's price, the potential premium of the option also increases, making it more valuable to investors.

Options traders often view a more volatile stock as a greater opportunity for profit since price movements can lead to more favorable outcomes for option holders. Therefore, as volatility increases, the perceived risk and reward associated with the option rises, leading to higher premiums and justifying the correct choice of how volatility impacts an option's price.