The Dow got absolutely crushed yesterday, and based on how the futures were reacting this morning…it appears that isn’t a one-off.
That said, whenever the market sells off as hard as it did, we know one thing—implied volatility in options explodes. That means options across the board become way more expensive, especially if you are looking at put options.
Understanding how the changes in implied volatility combined with the underlying price can either land you hugely profitable trades or leave you with a loser.
Today I want to talk to you about how implied volatility plays a role during market sell-offs. And how it can impact your trading (good and bad).
A price chart of the SPY and the VIX will show the inverse relationship between a stock’s price and implied volatility.
Typically, as a stock is rising in price, the implied volatility will decrease, and when a stock price is decreasing, the implied volatility will increase.
This type of inverse relationship between stock price and implied volatility is what drives the phenomenon known as vol collapse that is seen by options traders.
Figure 1 : SPY daily price chart plotted along with a VIX daily price chart.
It’s important to note that buying calls near market bottoms actually results in paying higher premiums for the same contracts contracts.
Due to the increase in implied volatility that is seen in the markets.
And the worst part about this is when the markets finally reverse back in the direction expected by the trader, the premium evaporates as the markets fears subside. This is also known as a vol collapse.
This is that inverse relationship with implied volatility and often times completely undermines the profit potential of the call buyer.
Impacts of IV on Options Pricing
As described earlier, there is an inverse relationship to the price of the markets and implied volatility.
This is where things get confusing.
Implied volatility has an inverse relationship with the markets, but has a positive relationship to the options prices.
So therefore, as implied volatility increases (from a decreasing market), options prices (both calls and puts) are increasing.
In other terms…
Long puts are positively impacted from a fall in SPY but also from the corresponding rise in implied volatility.
Alternatively, long calls are positively impacted from a rise in SPY and see a negative impact from the fall in implied volatility.
|Rise in SPY||Fall in IV||Fall in SPY||Rise in IV|
Above is a table to help understand the remaining set of options that are impacted by a change in the underlying market and implied volatility.
So…How does this impact a trader’s decision?
Let’s take a closer look…
Long Calls at Market Bottoms Are Expensive
For example, suppose a trader feels the market has declined to a point where it is oversold and due for at least a counter-trend rally.
Now, this is where it gets tricky.
Even though the trader correctly anticipates the turn in market direction, they may soon discover that the gains are much smaller or potentially non-existent after the move higher, depending on how much time has elapsed.
So why is that?
Well, long calls suffer from a fall in implied volatility (the market rallying higher) and this can outweigh the gains from a rise in the underlying stock price.
When traders purchase long call options at the market bottom, they are actually purchasing “expensive” options due to a rise in implied volatility.
And when the underlying stock rises, implied volatility can decline dramatically, in turn causing the price of the option to fall greater than the amount gained by their delta, or the underlying stock price.
Let’s take a look at how a trader can take advantage of the positive impact of both direction and IV using long puts.
Long Puts to Trade Momentum
Opposite of that last example, let’s assume the trader believes the market is going to go lower instead of higher after it has sold off.
Here is an example premarket chart as a reference on the SPY’s.
Now imagine coming into this mayhem?
Well that’s what we faced on 2/24/2020 when more news of the CoronaVirus spread throughout the world.
Now… the viewpoint going into the open was naturally extremely bearish and for good reason!
So how would a trader capitalize on this using options?
Instead of using a put spread for a raw directional move, it’s actually better to use a single put option.
This is because a put spread negates the effects of vega and implied volatility on your trade, and leaves you with strict delta exposure..
And also a long put option takes advantage of a directional move and a rise in implied volatility.
So since we are bearish, it makes the most sense to go long puts on a market option like this.
And that’s exactly what I did!
So let’s take a look at how this played out on a chart of the markets including the implied volatility chart.
As you can tell from the chart, the market continued to fall throughout the morning.
And from the market continuously selling off this drove implied volatility higher.
So this trade that was a long put option made money in multiple ways!
The long put got a boost in profits from
- The correct direction
- A boost in implied volatility
So this is the bottom line…
Even if you correctly forecast a market rebound and attempt to profit from buying an option, you may or may not receive the profits you were expecting due to a dramatic collapse in implied volatility levels.
In turn, that is why it’s best to utilize trading strategies such as vertical spreads to eliminate the effects of Vega from the position.
And when trading momentum at or new market bottoms, a trader can still greatly capitalize on the added boost from increased implied volatility and the correct movement in the underlying stocks price.
This in fact makes for a better time to use strict long put options instead of a vertical put spread or even the underlying stock! After all – the underlying stock doesn’t let a trader capitalize on the correct direction and the implied volatility spike.