Dear David,
Appreciate your enlightenment on the FRM handbook question (page 335 Example 13.3 5th edition) below. The book’s explanation is that the long call position is profitable when the actual volatility is small but this statement seems contradictory to what I’ve learned about long options that long a option is long implied volatility therefore it benefits from increasing volatility?
Example 13.3
A trader buys an at-the-money call option with the intention of delta-hedging it to maturity. Which one of the following is likely to be the most profitable over the life of the option?
A. An increase in implied volatility
B. The underlying price steadily rising over the life of the option
C. The underlying price steadily decreasing over the life of the option
D. The underlying price drifting back and forth around the strike over the life of the option
Answer Provided: D
Thanks
Liming
19/11/09
One of the possible explanation is in the purpose for which the call option is purchased. Remember this is not just a long call option, it is a long call option bought for hedging purposes. So the trader who has bought this option would actually prefer low volatility (or back and forth over the strike price) so that his hedging costs do not increase due to transaction costs. (If the underlying price increased a lot, Delta would increase and he would have to sell some of the options thus increasing costs due to transactions)