Chartered Financial Analyst (CFA) Practice Exam Level 2

How is the volatility of an option's price typically measured?

1. By analyzing trading volume

2. By examining market sentiment

3. By measuring changes in delta

4. By assessing Vega

The correct answer is: By assessing Vega

The volatility of an option's price is typically measured by assessing Vega. Vega quantifies the sensitivity of an option's price to changes in the volatility of the underlying asset. Specifically, it indicates how much the price of the option is expected to change for a one percentage point change in implied volatility. When the implied volatility of the underlying asset increases, the price of the option generally increases as the likelihood of the option finishing in-the-money rises. Therefore, Vega is a crucial Greek that helps options traders understand how much the prices of their options might fluctuate due to changes in expected market volatility. This makes it an essential measure for evaluating the potential risks and rewards associated with options trading. In contrast, analyzing trading volume, examining market sentiment, and measuring changes in delta do not directly indicate the volatility of the option's price. Trading volume may reflect market interest but doesn't provide a direct measure of price volatility. Market sentiment offers insights into trader attitudes but fails to quantify the volatility itself. Changes in delta represent the sensitivity of an option's price to changes in the underlying asset's price, rather than volatility.