Supply and Demand: Not Just a Good
Idea, It’s the Law!
Options are an excellent vehicle for speculation. However, the existence of
the options market is better justified by the primary economic purpose of
options: as a risk management tool. Hedgers use options to protect their
assets from adverse price movements, and when the perception of risk
increases, so does demand for this protection. In this context, risk means
volatility—the potential for larger moves to the upside and downside. The
relative prices of options are driven higher by increased demand for
protective options when the market anticipates greater volatility. And option
prices are driven lower by greater supply—that is, selling of options—when
the market expects lower volatility. Like those of all assets, option prices
are subject to the law of supply and demand.
When volatility is expected to rise, demand for options is not limited to
hedgers. Speculative traders would arguably be more inclined to buy a call
than to buy the stock if they are bullish but expect future volatility to be
high. Calls require a lower cash outlay. If the stock moves adversely, there
is less capital at risk, but still similar profit potential.
When volatility is expected to be low, hedging investors are less inclined
to pay for protection. They are more likely to sell back the options they may
have bought previously to recoup some of the expense. Options are a
decaying asset. Investors are more likely to write calls against stagnant
stocks to generate income in anticipated low-volatility environments.
Speculative traders will implement option-selling strategies, such as short
strangles or iron condors, in an attempt to capitalize on stocks they believe
won’t move much. The rising supply of options puts downward pressure on
option prices.
Many traders sum up IV in two words: fear and greed . When option
prices rise and fall, not because of changes in the stock price, time to
expiration, interest rates, or dividends, but because of pure supply and
demand, it is implied volatility that is the varying factor. There are many
contributing factors to traders’ willingness to demand or supply options.
Anticipation of events such as earnings reports, Federal Reserve