Implied Volatility and Direction
Who’s afraid of falling stock prices? Logically, declining stocks cause
concern for investors in general. There is confirmation of that statement in
the options market. Just look at IV. With most stocks and indexes, there is
an inverse relationship between IV and the underlying price. Exhibit 3.2
shows the SPX plotted against its 30-day IV, or the VIX.
EXHIBIT 3.2 SPX vs. 30-day IV (VIX).
The heavier line is the SPX, and the lighter line is the VIX. Note that as
the price of SPX rises, the VIX tends to decline and vice versa. When the
market declines, the demand for options tends to increase. Investors hedge
by buying puts. Traders speculate on momentum by buying puts and
speculate on a turnaround by buying calls. When the market moves higher,
investors tend to sell their protection back and write covered calls or cash-
secured puts. Option speculators initiate option-selling strategies. There is
less fear when the market is rallying.
This inverse relationship of IV to the price of the underlying is not unique
to the SPX; it applies to most individual stocks as well. When a stock