Options Theory: Implied Volatility Cycle
May 6, 2021
Last Update: August 2021
Matt & Tim recently discussed the implied volatility cycle on the Trading Justice Podcast. You can listen to it in the player below. Today I want to throw my own hat in the ring and explain the concept in print. Let’s take this from the ground up.
Trading Justice 422: The Implied Volatility Cycle
What is Implied Volatility?
Implied volatility is a metric traders use to gauge the supply and demand for options. And since supply and demand are what drive the premium of an option, implied volatility also reflects an options’ cost.
Here’s how it works.
- Demand rises, options premiums expand, implied volatility climbs.
- Demand falls, options premiums shrink, implied volatility declines.
Using the transitive property, we can modify the statement. Side note for those that don’t remember this property from Math class. It states: If A = B and B = C, then A = C.
- (A) Demand rises = (B) Options Premiums Expand
- (B) Options Premiums Expand = (C) Implied volatility rises
- (A) Demand rises = (C) Implied volatility rises
IV and Earnings
Since demand for an option ebbs and flows over time, implied volatility (IV) does likewise. And, when you study IV you discover its movements aren’t entirely random. Demand for options tends to increase ahead of quarterly earnings reports because they bring higher uncertainty and volatility (usually large gaps). This is logical behavior. Wouldn’t you be willing to pay more for a call or put option ahead of an event where the stock is expected to move 2x or 3x what is normal?
Or, consider it from the seller’s perspective. If you were shorting a call or put right before the uncertainty of earnings, wouldn’t you demand more compensation for the elevated risk you’re taking?
The gradual rise in implied volatility into these quarterly events is known as a volatility build.
Now think about how demand might change after the report. At that point, the cat is out of the bag. With the heavy uncertainty now in the rearview mirror, volatility expectations quickly revert back to normal. This is known as a volatility crush.
Bears Interrupt the Cycle
In a vacuum, the IV cycle would be extremely consistent each quarter. In the real world, however, it’s rarely as clean. The reason is two-fold. First, sometimes company-specific news crops up that cause sharp changes in the stock price and an equally sharp change in demand for derivatives. Second, when the entire stock market suffers a correction or bear market, you will see implied volatility spike across the board. This is also logical. In times of turmoil, it’s almost as if each day is an earnings move. No need to wait for the quarterly report for elevated uncertainty. It’s already here!
Consider the following example of Alphabet stock. The IV cycle was consistent throughout the past two years with one major exception: March 2020. The pandemic ushered in a massive bear market that jammed implied volatility to the moon. Earnings gaps paled in comparison to the daily swings that Alphabet was seeing. Notice, however, that as the bear market ended and Alphabet returned to its normal trend, the implied volatility cycle also returned.
The Strategy Matrix
Analyzing implied volatility helps with strategy selection. Some options trades are known as positive vega (or long volatility) and are best entered when implied volatility is low. Such trades as long calls, bull calls, and calendars fall under this banner. Other strategies are known as negative vega (or short volatility) and are best entered when implied volatility is high. This includes trades like naked puts, credit spreads, and iron condors.
If you need help with remembering which strategies go where then read the February Trading Justice Newsletter titled The Definitive Guide on Options Strategy Selection.
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