The successful option trader needs to know not only how a change in the underlying stock or index will impact on position profitability, but also how time and a change in implied volatility will affect the position.
Time moves predictably in one direction and its effect is easy to predict with a simple option price calculator. Volatility on the other hand is complex and less easy to forecast. There is however an anecdotally described relationship, with solid empirical data to support it that in 30 years academics have not been able to adequately explain. This relationship, once understood by option traders and assimilated into their option trading strategies will provide them a sustainable trading edge.
One of the most enduring empirical regularities in equity markets is the inverse relationship between stock prices and volatility. This was first documented by Black in 1976 who attributed it to a relationship called the 'Leverage Effect'. Simply put, for a company funded by a combination of debt plus equity, as the share price falls, the debt remains constant and the equity falls, and this induces a higher equity-return volatility.
Academics in more recent times have tried to prove the Leverage Effect by comparing the share price to volatility relationship for all-equity companies with debt-equity companies. They have not been able to prove the existence of the Leverage Effect. Instead, the finance theoreticians have named this relationship the 'Down Market Effect.' The academics explain the inverse relationship between share market performance and implied volatility is a combination of time-varying risk premiums and cognitive mechanisms of risk perception – or more simply that traders and investors have a lower appetite for risk in a falling market than a rising one .
The Down Market Effect can be observed when share prices fall, realised and implied volatility increase. My own testing suggests implied volatility is more responsive to share prices than realised volatility. That is, implied volatility relationship overreacts to a move in the underlying index.
The relationship does not appear linear. An increase in stock market index levels is associated with a small decrease in implied volatility while an equivalent decrease in the index accompanies a much larger increase in implied volatility.
The Down Market Effect is observed widely in stock market indices around the globe. It is also apparent in individual stocks, although in the absence of stock specific news, stock implied volatility seems more related to wider market returns.
What implications does the Down Market Effect have for option traders? Simplistically, that it is better to be net long vega when stock market prices are falling and to be short vega when stock market prices are increasing. For example, buying put options to profit from a falling market is will be more profitable than selling call options as the increase in implied volatility will favour the long puts, but be detrimental to the short calls. Ratio call and put strategies are the best way to achieve a target vega given constraints of delta (exposure to move in the underlying) and theta (time decay).
To summarise, one of the most enduring empirical regularities in equity markets is the inverse relationship between stock prices and volatility. This is called the Down Market Effect and is best explained by traders' lower appetite for risk in a falling market. The relationship is not linear. Implied volatility increases much more in a falling market than it falls in a rising market. Implied volatility is also more responsive to changes in share market prices than realised volatility. The Down Market Effect has major implications for option traders. Simplistically, that it is better to be net long vega when stock market prices are falling and to be short vega when stock market prices are increasing.