7. Realized Volatility Falls, Implied
Volatility Rises
This setup shown in Exhibit 14.8 should now be etched into the souls of
anyone who has been reading up to this point. It is, of course, the picture of
the classic IV rush that is often seen in stocks around earnings time. The
more uncertain the earnings, the more pronounced this divergence can be.
EXHIBIT 14.8 Realized volatility falls, implied volatility rises.
Source : Chart courtesy of iVolatility.com
Another classic vol divergence in which IV rises and realized vol falls
occurs in a drug or biotech company when a Food and Drug Administration
(FDA) decision on one of the company’s new drugs is imminent. This is
especially true of smaller firms without big portfolios of drugs. These
divergences can produce a huge implied–realized disparity of, in some
cases, literally hundreds of volatility points leading up to the
announcement.
Although rising IV accompanied by falling realized volatility can be one
of the most predictable patterns in trading, it is ironically one of the most
difficult to trade. When the anticipated news breaks, the stock can and often
will make a big directional move, and in that case, IV can and likely will
get crushed. Vega and gamma work against each other in these situations, as