There is a long history in the equity markets of implied volatility increasing as the markets fall and, to a lesser degree, of implied volatility falling as the markets climb.
As bad news begins to be reflected in stock prices, the future volatility of those stock prices tends to increase because stock prices and stock market volatility are negatively correlated—they tend to go in opposite directions. We first discussed the need for investors to be compensated for additional volatility (which is really risk) in Part One. Conversely, when good news begins to be reflected in stock prices the future volatility of those stock prices tends to decrease. Unfortunately, future volatility doesn’t decrease as fast, or by as much as, it increases. This mismatch is often referred to as volatility asymmetry—volatility, both realized and implied, moves in the opposite direction of the underlying market, and it goes up a lot faster than it goes down.
THE CORRELATION BETWEEN MARKET PRICES AND IMPLIED VOLATILITY
This negative correlation is most evident in index options and less so (sometimes much less so) in options on individual equities, but how big can this negative correlation between market direction and volatility be over time? A little blip in the price of the S&P 500 shouldn’t have much of an effect on implied volatility, should it? We’ll focus on implied volatility because it’s the real cost of the options we want to trade, and because changes in implied volatility ...