Monday, November 2, 2009

The Cycle of Implied Volatility

Much to my satisfaction the polls seemed to work without a hitch. Thanks to those of you who participated.

My thoughts on the outcome?

Well, I'm pleased to state that the majority of us grasp the basics of reading a volatility chart. Let's delve into the answers and see if I can shed some insight on the rationale behind each answer, starting with question #1.
So 90% answered correctly in stating that quarterly earnings announcement are the usual catalyst behind the cyclical rise and fall of implied volatility. I'm hoping the rationale is obvious, but for those not yet comfortable with the nuances of option prices, allow me to elaborate. The following two assertions have helped me better understand options:

Options are Insurance
Volatility is the Price of Insurance

Just as any insurance company adjusts the price of insurance based on the risks inherent to each individual client, the market place adjusts the price of each option based on the perceived risks of the underlying stock going forward. Though an actual insurance company thinks of "risk" as likelihood of injury or sickness, option traders think of "risk" as likelihood of a large move in the underlying stock. If the stock is perceived to have higher risk of a large move going forward, options become more expensive (implied volatility increases). If the stock is perceived to have less risk of a large move going forward, options become cheaper (implied volatility decreases).

[Source: Livevol Pro]

So options are continually seeking to price in or discount how much volatility a stock is likely to realize in the future. Since earnings announcements almost always cause an increase in realized volatility, options seek to accurately price in this uptick in realized vol before it happens. Thus, there is almost always a rise in implied volatility in anticipation of the event.

What about after earnings?

Typically stocks revert back to their normal price behavior post earnings. With the catalyst in the rear view mirror, options also revert back to pricing in a stocks normal realized volatility. So, we usually see a sharp decrease in implied volatility to bring it more in line with reality, or at least the reality option traders expect to see going forward. Naturally this cyclical rise and fall in implied volatility should be taken into consideration by volatility traders seeking to buy low and sell high.

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