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By John Summa, CTA, PhD, Founder of OptionsNerd.com

Implied volatility levels were shown previously to move inversely to the price of most big cap stocks and options on major market averages. In the previous chapter on valuation, we presented past implied volatility (IV) and historical volatility levels for Altria Group, Inc. (NYSE:MO) that made this relationship very clear. However, for many stocks and commodities, this relationship does not apply. Often, high IV levels flag an impending price explosion - moves that may be up or down and that are accompanied by a collapse back to normal IV levels. You will see this pattern repeat again and again, most often in biotech stocks, but even in other tech names. (For related reading, see The Ups And Downs Of Biotechnology.)


In this segment, an example is presented to illustrate this alternative view of the price-volatility relationship. In the following segment, we will return to the inverse relationship to explore ways to predict market swings using extreme IV levels (looking at the VIX as an example) to go against the extreme crowd psychology threshold points. (For background reading, see The Price-Volatility Relationship: Avoiding Negative Surprises.)


High IV and Price Explosions
Recall how price and IV were shown to move inversely, as seen in Figure 16. Figure 16 presents weekly price bars for the S&P 500 alongside levels of IV (measured in the VIX index) and historical volatility. Here it is possible to see how price and volatility relate to each other. Typical of most big cap stocks that mimic the market, when price declines, volatility rises and vice versa.

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Figure 16: S&P 500 Weekly Price & Volatility Charts. Yellow bars highlight areas of falling prices and rising implied and historical volatility. Blue bars highlight areas of rising prices and falling implied volatility.


At high levels of IV, the market has been very bearish and at low levels of IV the market has generally been bullish. However, not all stocks behave this way. Spikes up in IV may be associated with little or no movement of the stock price when the levels remain high. Typically, this occurs when there is an approaching corporate news event, which drives up option prices while the stock quiets down (historical volatility would be falling in this case). Figure 17 presents the example of AtheroGenetics (Nasdaq:AGIX), which shows several periods of sharply rising IV ahead of big price moves.

Following the sharp rise in IV levels seen in late February and early March 2007, which preceded the release of phase III trials for the company's heart disease drug, the stock plunged when the trial results disappointed. The stock dropped 71.8% in two sessions following the bad news. And with the price drop, IV levels can be seen collapsing back to the 100% level from just over 275%. Another spike higher in IV can be seen in September 2004, where IV rose from just above 50% up to 150% rather quickly, which flagged an impending sharp rise in the stock price.

While volume is not shown here, there will also usually be associated rising volume levels compared with average levels. IV will rise compared with average levels, and it is a good idea to use a daily IV calculation and look at this number in relation to different moving averages of IV (traders will typically use 10- 20- and 30-day IV moving averages).

You can also compare daily IV to moving averages of historical volatility for a clue about an increase in speculative demand for the options, which will be captured in the rising IV relative to average historical volatility. Traders with insider information might be taking highly leveraged positions, and traders who watch those traders, so generally you will get rising volume and IV levels together, although not always.

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Figure 17: AtheroGenetics (AGIX) Weekly Price & Volatility Charts. Yellow bars highlight areas of rising IV preceding big price moves.

As is clear in Figure 17, there is a divergence of implied volatility from historical volatility ahead corporate news, which often gets reversed once the news is out. Historical volatility may even go higher with a big price move following the event, while IV collapses back to a normal level. In Figure 17, IV (blue line) often begins to diverge sharply from historical volatility levels (brown line), and in some instances, historical volatility will move in an opposite direction to IV as the stock price volatility dampens ahead of the explosion in price that follows a run-up in IV.





Trading this information is difficult because the direction of the price move is not known. While it is possible to try to see what insiders are doing and to mimic their behavior, this is not always easy and may lead to erroneous results. Buying out-of-the-money options is a poor strategy even if you know which way the stock is headed. This is because the options are trading at extreme price levels, as indicated by the sky-high IV. When the move occurs, assuming you bought the right options, the collapse in IV will often erase most of he gains. Selling strategies, meanwhile, may pose a problem because the price moves can be so big that you may find that the risk is not worth the reward. While there are other ways to trade these high IV levels, the topic is outside the scope of this tutorial. The important point is to know how IV can be used to scan for stocks that ready to make explosive moves and what this means in terms of option pricing.


Conclusion
This segment of the volatility tutorial provides a look at using IV to flag impending stock moves. Ahead of corporate news events (takeovers, drug trial results, etc.), speculators will buy options and push premiums up, which are reflected in sharply higher IV levels. Whether the speculators know something or not, the point is that IV levels at least can tell you that something is brewing. When the news event occurs, IV levels typically return to more normal levels, which will cause the high option prices to deflate. This makes a buying approach difficult, although not impossible.


Next: Option Volatility: Contrarian Indicator »


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