Whether you are considering purchasing a put Or purchase optionit is useful to know much more than the impact of a movement in the underlying on the price of your option. Often, option prices seem to have a life of their own, even when markets are moving as expected. A closer look, however, reveals that a change in implied volatility is usually the culprit.

While knowing the effect of volatility on option price behavior can help cushion against losses, this can also add a nice prime to winning trades. The trick is to understand the price-volatility dynamic, that is, the historical relationship between directional changes in the underlying and directional changes in volatility. Fortunately, this relationship in stock markets is easy to understand and quite reliable.

The price-volatility relationship

A price table of S&P500 and the implied volatility index (VIX) for options traded on the S&P 500 shows that there is an inverse relationship. As shown in Figure 1, when the price of the S&P 500 (top chart) falls, implied volatility (bottom chart) increases, and vice versa.

Figure 1: Daily VIX

The impacts of price and volatility changes on options

The table below summarizes the important dynamics of this relationship, indicating with the “+” and “-” signs how the evolution of the underlying and the associated evolution of the implied volatility (IV) each affect the four types of firm positions. For example, two positions have “+/+” in a particular condition, meaning they are positively impacted by changes in price and volatility, making these positions ideal in that condition: Long puts are positively affected by a drop in the S&P. 500 but also from the corresponding increase in implied volatility, and short puts receive a positive impact from both price and volatility with an increase in the S&P 500, corresponding to a decrease in implied volatility.

Table 1: Impact of price and volatility changes on long and short option positions

But contrary to their “ideal” conditions, long put And short put experiment with the worst possible combination of effects, marked with “-/-“. Positions with a mixed combination (“+/-” or “-/+”) receive a mixed impact, meaning that price movements and implied volatility changes work in a contradictory manner. This is where you will find your volatility surprises.

For example, let’s say a trader believes that the market has declined to the point where it is oversold and due to at least one counter-trend rally. (See Figure 1 where an arrow points toward a rise in the S&P 500.) If the trader correctly anticipates the shift in the direction of the market (i.e., picks a market down) by purchasing one purchase optionthey may find that gains are much smaller, or even non-existent, after the upward move (depending on how much time has passed).

Recall from Table 1 that a long call suffers from a drop in implied volatility, even if it benefits from an increase in price (indicated by “+/-“). And Figure 1 shows that VIX levels plunge as the market rises: fear subsides, which is reflected in a falling VIX, leading to a falling VIX. prime levels, even if the price rise increases call bonus price.

Long Call Options at Market Bottoms Are “Expensive”

In the example above, the buyer of the call at the bottom of the market ends up buying very “expensive” options that, in fact, have already priced in an upward movement in the market. The premium can decrease significantly due to falling implied volatility levels, neutralizing the positive impact of a rising price, leaving the unsuspecting buy buyer miffed as to why the price has not not appreciated as expected.

Charts 2 and 3 below illustrate this disappointing dynamic using theoretical prices. In Figure 2, after a rapid move of the underlying up to 1205 from 1185, there is a profit on this hypothetical out of money February 1225, long call. The move generates a theoretical profit of $1,120.

Figure 2: Profit/Loss of long call options with no change in implied volatility

But this benefit assumes no change in implied volatility. When making a speculative purchase near a market bottom, it is reasonable to assume that a drop of at least 3 percentage points in implied volatility occurs with a market. bounce of 20 points.

Figure 3 shows the result once the volatility dimension is added to the model. Now the profit from the 20-point move is only $145. And if in the meantime some time value decay occurs, then the damage is more severe, indicated by the immediately lower profit/loss line (T+9 days after the start of the trade). Here, despite the increase, the profit turned into losses of around $250!

Figure 3: Profit/Loss of long call options with 3 percentage point drop in implied volatility

One way to reduce the damage caused by volatility changes in a case like this is to buy a bull call spread. More aggressive traders may want to establish short put options or put spreads, which have a “+, +” relationship with rising prices. Note however that a drop in price has a “-/-” impact for the put sellerswhich means that positions will suffer not only from falling prices but also from increasing implied volatility.

Long positions at market tops are “cheap”

Now let’s take a look at buying a long put. Here, choosing a market top by entering a long put option has an advantage over choosing a market bottom by entering a long call option. This is because long puts have a “+/+” relationship with price changes/implied volatility.

In Figures 4 and 5 below, we have set up a hypothetical long put option off the February 1125 price. In Figure 4, you can see that a quick drop in price from 20 points down to 1 165 with no change in implied volatility leads to a profit of $645. (This option is further from the money, so it has a smaller deltaleading to a smaller gain with a 20 point move compared to our hypothetical 1225 call option, which is closer to the money.)

Figure 4: Profit/loss on long-term put options with no change in implied volatility

Figure 5: Profit/loss on long-term put options with implied volatility increasing by 3 percentage points

Meanwhile, looking at Figure 5, which shows an increase in implied volatility of three percentage points, we see that profit is now increasing to $1,470. And even with the decadence of time value occurring at T+9 days after the start of the transaction, the profit is almost $1,000.

Therefore, speculating on market declines (i.e., trying to pick a top) by purchasing puts has a built-in implied volatility advantage. What makes this strategy more attractive is that at market highs, implied volatility is typically extremely low, so a put buyer would buy very “cheap” options that don’t have too much volatility risk built into them. in their prices.

The essentials

Even if you correctly forecast a market rebound and try to make a profit by purchasing an option, you may not receive the expected profits. The decline in implied volatility during market rallies can cause negative surprises by counteracting the positive impact of rising prices. On the other hand, buying puts at market highs can potentially deliver positive surprises, as falling prices push implied volatility levels higher, thereby adding additional potential profit to a long option purchased very “cheap”. Being aware of price volatility dynamics and its relationship to your option position can significantly affect your trading performance.