How Do Volatility and Market Depth Interact to Affect Option Premium Pricing?
High volatility increases the probability of extreme price movements, which increases the option's premium (price) as the chance of a profitable exercise rises. Low market depth, often correlated with high volatility, also contributes to a higher premium because it implies a higher cost and risk for the option writer to hedge their position in the underlying asset.
Therefore, high volatility and low depth typically push option premiums higher.
Glossar
Volatility and Market Depth
Volatility ⎊ Volatility measures the magnitude of price fluctuations in an asset, representing a key risk factor in derivatives trading.
Market Depth
Capacity ⎊ This refers to the aggregate size of limit orders resting on the bid and ask sides of the order book at various price increments away from the mid-price.