Tuesday, November 10, 2009

Implied Volatility: The Supply-Demand Factor

The fourth and final question from the volatility quiz cut to the heart of the matter by asking what it means when implied volatility declines. The results weren't as stellar with this question as only 71% answered correctly by stating that when implied volatility increases, demand for that option has increased.
My guess is that some aren't clear on how supply and demand work to influence option prices, so let's see if I can shed some insight based on my understanding. Within the options market, as with any competitive market, prices fluctuate as a function of supply and demand. More demand than supply, prices typically rise. More supply than demand, prices typically fall. Just because option traders may use a theoretical pricing model, such as Black-Scholes, to derive a fair or theoretical value for each option, doesn't mean that the option prices won't fluctuate above or below that "fair value" based on supply and demand.

Assuming all other variables stay constant (time to expiration, stock price, interest rates, etc...), we could make the following assertions:

If demand for an option increases, option prices will increase. If option prices increase, implied volatility will increase.

If supply of an option increases, option prices will decrease. If option prices decrease, implied volatility will decrease.

For example, with the S&P 500 Index (SPX) currently trading around 1095, let's say the December 1000 put is worth $6.50. If we plug this value into an options calculator we can see if the 1000 put is trading at $6.50, implied volatility would be 26%

[Source: CBOE]
Let's say a big buyer comes in and aggressively buys 10,000 contracts of the Dec 1000 put. Due to this increased demand, suppose the put rises in value to $12. If all other variables remain constant, the implied volatility of the put would rise to 33%.

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