In early chapters, we saw that implied volatility moves inversely to the price of most big cap stocks and options on major market averages. We also looked at implied and historical volatility levels for Altria Group, Inc. which helped to illustrate this relationship. It’s important to keep in mind, though, this relationship does not apply for many stocks and commodities. In many cases, high IV levels indicate an impending price explosion (which may be up or down and which will lead to a collapse back to normal IV levels). This pattern repeats over and over again in many areas, particularly in the biotech sector. (For related reading, see The Ups And Downs Of Biotechnology.)
In this chapter, we’ll take a look at an example which illustrates this alternative view of the relationship between price and volatility. Then, we’ll return to the inverse relationship to explore ways in which market swings can be predicted by use of extreme IV levels. (For background reading, see The Price-Volatility Relationship: Avoiding Negative Surprises.)
In Figure 1, recalled from the previous chapter and showing the S&P 500 weekly price and volatility, we saw that price and IV were moving inversely to one another. Here, we observe weekly price bars for the S&P 500 alongside levels of I (measured in the VIX index) and historical volatility. In this chart, it’s possible to see just how price and volatility relate to each other; like most big cap stocks which mimic the market, as price declines, volatility rises. The inverse is also true.
Figure 1: S&P 500 Weekly Price & Volatility Charts. Yellow bars highlight areas of falling prices and rising implied and historical volatility. Blue bars highlight areas of rising prices and falling implied volatility.
For high levels of IV, it’s common for the market to be bearish; at low levels of IV, the market may be bullish. However, this is not always the case, and not all stocks behave in this way. Sometimes, spikes upward in IV are associated with very little movement of the stock price when the levels remain high. This most often occurs if there is an approaching corporate news event (this tends to drive up option prices while the stock itself quits down, meaning that historic volatility falls). Figure 2 is a historical view of AtheroGenetics from 2003 through 2007, and this chart shows a number of periods of sharply-rising IV ahead of large price moves.
There is a sharp rise in IV levels in late February and early March of 2007 according to this chart. This preceded the phase III trials for a major heart disease drug. The stock plunged after the trial results disappointed, with the value dropping by 71.8% in two sessions following the results. With the price drop, IV levels collapsed back to the 100% level (they had previously been built up to around 275%). There was another spike in IV back in September of 2004, when IV rose from 50% or so up to 150% over a short period of time, flagging an impending sharp rise in the stock price.
This chart does not show volume, but there is often an associated rising volume level as compared with average levels. When IV rises compared with average levels, it’s a good idea to track the IV level daily for comparison and monitoring (traders often use 10-, 20-, and 30-day IV moving averages for this purpose).
One can also compare daily IV to moving averages of historical volatility. This provides insight into why there may be increased speculative demand for options. Traders with insider information might be taking highly leveraged positions, as will traders who watch those traders. For these reasons, you often see rising volume and IV levels at the same time, although not all the time.
In Figure 2, we see a divergence of implied volatility from historical volatility ahead of big corporate news. This is often reversed once the news has been released. If there is a big price move following the event, historical volatility might even go higher, while IV collapses back to its normal range. The blue line in Figure 2 (representing IV) often diverges sharply from historical volatility (the brown line). In some instances, historical volatility actually moves in the opposite direction from IV as the stock price volatility lessens ahead of a price explosion which follows rapid gains in IV.
Of course, trading based on the information above is difficult for the reason that the direction of the price move is not known. It’s certainly possible to find insiders and mimic their behavior, it’s by no means a guarantee of successful trading. Buying out-of-the-money options is usually a poor strategy, even if you know which way the stock is moving. The reason for this is that the options are trading at extreme price levels (indicated by high IV). When the move occurs, and assuming that you bought the correct options, the collapse in IV usually eliminates most of the gains. Selling strategies, on the other hand, may pose a problem because the price moves are often so large that the risk outweighs the reward. That’s not to say that there aren’t ways to trade these high IV levels, only that they are more complicated than the scope of this tutorial will allow. The most important takeaway, then, is to know how IV can be used to scan for stocks that are ready to make explosive moves and what this means as far as option pricing is concerned.
In this chapter, we examined how to use IV to flag impending stock moves. Speculators often buy options and push premiums up ahead of major corporate news events. These are then reflected in sharply higher IV levels, regardless of whether the speculators know something or not. Higher IV levels can tell you that something big is coming When the news event occurs, IV levels often return to more normal areas, and the high option prices then deflate. This can make a buying approach difficult, although it’s not necessarily impossible.