Volatility vs. Price
In stocks, 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, and deteriorating business conditions mean higher risk from worsened visibility. 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. Thus, stocks exhibit smaller daily price fluctuations, i.e., lower volatility.
Would logic dictate that the converse be true? Does a period of low volatility presage a drop in stock prices? While logic would not dictate this (it is 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.
In the illustration below, the solid red line represents statistical volatility (how much the price of the QQQ has bounced around recently). The dashed blue line represents implied volatility (how much underlying volatility is implied by current option price levels). Notice how often volatility peaks went with market bottoms, and volatility lows corresponded with market tops.
So what does this mean to the options trader? How can we profit from this information?
For one thing, volatility helps as a confirming indicator. When volatility is high, for example, you know that the bottom is near. When volatility is low, one must be on guard for a potential breakdown. Another thing is that this should make us want to buy options at market tops and sell options at market bottoms.
When volatility is low, we can watch for signs of a breakdown and go short by buying puts. One of the most reliable signals of a breakdown is when the market begins to fall off the right shoulder of a head-and-shoulders formation. The best strategy to use would probably be to buy puts, as options are cheap when volatility is low. If a selloff ensues, the options expand from the double effect of falling prices and (very likely) increasing volatility.
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. Of course, buying farther-out options costs more money, and they will respond more slowly to falling prices. However, as a lower-risk position, especially when compared with the “fast lane” nearby options, this may be appropriate. It is important for the trader to take appropriate risks according to his own goals and temperament.
Once prices begin to fall, and the options become expensive, if one still wanted to buy puts to play for further downside, he could switch to buying deep in-the-money nearby’s to avoid paying extra for the newly inflated time premiums.
When volatility is high, and prices are showing signs of bottoming (i.e., the chart is showing a double-bottom formation), this would suggest going long by selling naked puts, as options are expensive when volatility is high. If a rally materializes, the options die from both rising prices and falling volatility.
However, selling naked puts in the face of a down-trending market that you believe is about to reverse to the upside, is rather like standing on the tracks in front of an oncoming train and shouting, “Halt!” It might work, but it’s kind of scary. To reduce the stress to acceptable levels, one can simply use a small position, but then you don’t make much money when you’re right. Another approach is to use a credit spread. While a credit spread would not respond to declining volatility nearly as well, it does limit your risk. And finally, there is covered writing and covered combos (a covered write plus naked puts), both excellent strategies that put the odds in your favor by selling expensive options.
In practice, I have found the buying of puts at the start of a breakdown is far more rewarding than the selling of options (naked or covered) at a suspected bottom. Long puts expand dramatically during a market selloff. At a suspected bottom, sometimes I feel more comfortable just buying a few of my favorite stocks. If I feel strongly about my timing, I might even load up with extra shares “on margin” for a short time. Despite what they say about the risks of buying stock on margin, it can be less risky to do that than some of the options strategies you might employ at that juncture.