Understand Relationship between Price & Volatility

Since volatility is measured using percentage price variations, higher priced assets don’t exhibit higher volatilities just because of their higher price. Therefore, one would think that volatility and price would bear no correlation. However, it so happens that with most assets, volatility and price do exhibit some degree of correlation. In stocks, the correlation is a negative one; volatility increases as stock prices decline, and volatility declines as stock prices increase.

The reason volatility increases as stocks decline is presumably because falling stock prices mean deteriorating business conditions, which translates into higher risk and greater uncertainty. This leads to greater daily price fluctuations (on a percentage basis) and, thus, greater volatility.

On the other hand, as stock prices climb, this implies improving business conditions and greater stability. In that climate, stocks exhibit smaller daily price fluctuations (on a percentage basis)—in other words, lower volatility.

Would logic dictate that the converse be true? Does a period of low volatility presage a drop in stock prices? While it would be false logic to assume the converse is true, it turns out from historical observation that this is often the case. Does extremely high volatility mark the bottom of a bear market? Again, very often it does.

For one thing, volatility can be used as a confirming indicator. When volatility is high, for example, you know that the bottom is probably near. When volatility is low, one should be on guard for a potential breakdown. Also, the low volatility at market tops should make us lean toward buying options at those times, and the high volatility at market bottoms should make us want to sell options then.

To get more of a bang from a possible volatility increase, one could buy farther out options, as farther out options expand more when volatility increases. The downside is that the farther out options cost more money and respond more slowly to falling prices. However, they are a lower risk position compared with the “fast lane” nearby options. It is important for the trader to take appropriate risks according to his own goals and temperament.

Once prices are falling and the options are expensive, if a trader still wanted to buy puts in anticipation of a further price drop, he could switch to buying nearby options that are deep in-the-money to avoid paying extra for the inflated time premiums. Even when IVs are running high, the deep in-the-money nearbys typically hold very little time premium.

When volatility is high and the options are expensive, but the trader feels that prices are showing signs of bottoming, conditions would suggest going long by selling naked puts. If a rally materializes, the options will quickly lose value from both rising prices and falling volatility. However, selling naked puts in a down-trending market that you believe is about to reverse is rather like standing on the road in front of oncoming traffic and shouting “Stop!” It might work, but it’s kind of scary. 

To reduce risk (and stress!) to acceptable levels, one could simply take a small position, but that won’t make as much money when you’re right. Luckily, with options there are several other strategies you could use that allow you to limit the risk to an acceptable level. One approach would be to use a credit spread in puts. While a credit spread does not respond to declining volatility as well, it does make money in a rising market and limits your risk. Or a vertical debit spread in calls might make sense. Much of the high volatility is neutralized because you’re selling an expensive option at the same time that you’re buying an expensive option.

If you own, or would like to own, some shares of individual stocks at reduced prices, an approach to consider is the covered combo. With a covered combo, you buy (or already have) shares of the stock. You then sell both calls and naked out-of-the-money puts. Selling all these expensive options really places the odds in your favour. However, note that the short calls place a cap on your stock price appreciation.

In practice, I have found that buying puts at the start of a breakdown is far more rewarding than selling options (naked or covered) at a suspected bottom. Long puts expand in value dramatically during a market sell-off.

Happy Trading!!!

Cheers.