How Does a Sudden Drop in Implied Volatility Affect the Extrinsic Value of an ATM Option? ▴ Learn

How Does a Sudden Drop in Implied Volatility Affect the Extrinsic Value of an ATM Option?

A sudden drop in implied volatility (IV) will cause a significant decrease in the extrinsic value of an ATM option. Since ATM options have the maximum extrinsic value, they are the most sensitive to changes in IV (highest Vega).

A drop in IV reduces the option's volatility component, leading to a substantial reduction in the overall extrinsic value and thus the option's premium.

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