Supply and Demand-Not Just a Good Idea, It’s the Law!

Options are an excellent vehicle for speculation. However, the existence of the options market is better justified by the primary economic purpose of options: as a risk management tool. Hedgers use options to protect their assets from adverse price movements, and when the perception of risk increases, so does demand for this protection. In this context, risk means volatility—the potential for larger moves to the upside and downside.

The relative prices of options are driven higher by increased demand for protective options when the market anticipates greater volatility. And option prices are driven lower by greater supply—that is, selling of options—when the market expects lower volatility. Like those of all assets, option prices are subject to the law of supply and demand.When volatility is expected to rise, demand for options is not limited to hedgers.

Speculative traders would arguably be more inclined to buy a call than to buy the stock if they are bullish but expect future volatility to be high. Calls require a lower cash outlay. If the stock moves adversely, there is less capital at risk, but still similar profit potential.When volatility is expected to be low, hedging investors are less inclined to pay for protection. They are more likely to sell back the options they may have bought previously to recoup some of the expense.

Options are a decaying asset. Investors are more likely to write calls against stagnant stocks to generate income in anticipated low-volatility environments. Speculative traders will implement option-selling strategies, such as short strangles or iron condors, in an attempt to capitalize on stocks they believe won’t move much. The rising supply of options puts downward pressure on option prices.

Many traders sum up IV in two words: fear and greed. When option prices rise and fall, not because of changes in the stock price, time to expiration, interest rates, or dividends, but because of pure supply and demand, it is implied volatility that is the varying factor. There are many contributing factors to traders’ willingness to demand or supply options.Anticipation of events such as earnings reports, Federal Reserve announcements,or the release of other news particular to an individual stock can cause anxiety, or fear, in traders and consequently increase demand for options that causes IV to rise.

IV can fall when there is complacency in the market or when the anticipated news has been announced and anxiety wanes. “Buy the rumor, sell the news” is often reflected in option implied volatility. When there is little fear of market movement, traders use options to squeeze out more profits—greed.Arbitrageurs, such as market makers who trade delta neutral—a strategy that will be discussed further in Chapters 12 and 13—must be relentlessly conscious of implied volatility. When immediate directional risk is eliminated from a position, IV becomes the traded commodity.

Arbitrageurs who focus their efforts on trading volatility (colloquially called vol traders) tend to think about bids and offers in terms of IV. In the mind of a vol trader,option prices are translated into volatility levels. A trader may look at a particular option and say it is 30 bid at 31 offer. These values do not represent the prices of the options but rather the corresponding implied volatilities.The meaning behind the trader’s remark is that the market is willing to buy implied volatility at 30 percent and sell it at 31 percent.

The actual prices of the options themselves are much less relevant to this type of trader.Should HV and IV Be the Same?Most option positions have exposure to volatility in two ways. First, the profitability of the position is usually somewhat dependent on movement (or lack of movement) of the underlying security. This is exposure to HV.Second, profitability can be affected by changes in supply and demand for the options.

This is exposure to IV. In general, a long option position benefits when volatility—both historical and implied—increases. A short option position benefits when volatility—historical and implied—decreases.That said, buying options is buying volatility and selling options is selling volatility.It’s intuitive that there should exist a direct relationship between the HV and IV. Empirically, this is often the case.

Supply and demand for options, based on the market’s expectations for a security’s volatility, determines IV.It is easy to see why IV and HV often act in tandem. But, although HV and IV are related, they are not identical. There are times when IV and HV move in opposite directions. This is not so illogical, if one considers the key difference between the two: HV is calculated from past stock price movements; it is what has happened. IV is ultimately derived from the market’s expectation for future volatility.