Nine Volatility Chart Patterns

Each individual stock and the options listed on it have their own unique realized and implied volatility characteristics. If we studied the vol charts of 1,000 stocks, we’d likely see around 1,000 different volatility patterns.
The number of permutations of the relationship of realized to implied volatility is nearly infinite, but for the sake of discussion, we will categorize volatility charts into nine general patterns.

The first volatility chart pattern is that in which both IV and realized volatility rise. In general, this kind of volatility chart can line up three ways:implied can rise more than realized volatility; realized can rise more than implied; or they can both rise by about the same amount. The chart below shows implied volatility rising at a faster rate than realized vol.

The general theme in this case is that the stock’s price movement has been getting more volatile, and the option prices imply even higher volatility in the future.This specific type of volatility chart pattern is commonly seen in active stocks with a lot of news. Stocks du jour, like some Internet stocks during the tech bubble of the late 1990s, story stocks like Apple (AAPL) around the release of the iPhone in 2007, have rising volatilities, with the IV outpacing the realized volatility.

Sometimes individual stocks and even broad market indexes and exchange-traded funds (ETFs) see this pattern, when the market is declining rapidly, like in the summer of 2011.A delta-neutral long-volatility position bought at the beginning of May,according to Exhibit 14.1, would likely have produced a winner. IV took off,and there were sure to be plenty of opportunities to profit from gamma with realized volatility gaining strength through June and July.

Looking at the right side of the chart, in late July, with IV at around 50 percent and realized vol at around 35 percent, and without the benefit of knowing what the future will bring, it’s harder to make a call on how to trade the volatility. The IV signals that the market is pricing a higher future level of stock volatility into the options. If the market is right, gamma will be good to have.

But is the price right? If realized volatility does indeed catch up to implied volatility—that is, if the lines converge at 50 or realized volatility rises above IV—a trader will have a good shot at covering theta. If it doesn’t,gamma will be very expensive in terms of theta, meaning it will be hard to cover the daily theta by scalping gamma intraday.The question is: why is IV so much higher than realized?

If important news is expected to be released in the near future, it may be perfectly reasonable for the IV to be higher, even significantly higher, than the stock’s realized volatility. One big move in the stock can produce a nice profit, as long as theta doesn’t have time to work its mischief. But if there is no news in the pipeline, there may be some irrational exuberance—in the words of ex-Fed chairman Alan Greenspan—of option buyers rushing to acquire gamma that is overvalued in terms of theta.

In fact, a lack of expectation of news could indicate a potential bearish volatility play: sell volatility with the intent of profiting from daily theta and a decline in IV. This type of play, however, is not for the fainthearted. No one can predict the future. But one thing you can be sure of with this trade: you’re in for a wild ride. The lines on this chart scream volatility.

This means that negative-gamma traders had better be good and had better be right!In this situation, hedgers and speculators in the market are buying option volatility of 50 percent, while the stock is moving at 35 percent volatility. Traders putting on a delta-neutral volatility-selling strategy are taking the stance that this stock will not continue increasing in volatility as indicated by option prices; specifically, it will move at less than 50 percent volatility—hopefully a lot less.

They are taking the stance that the market’s expectations are wrong.Instead of realized and implied volatility both trending higher, sometimes there is a sharp jump in one or the other. When this happens, it could be an indication of a specific event that has occurred (realized volatility) or news suddenly released of an expected event yet to come (implied volatility).

A sharp temporary increase in IV is called a spike, because of its pointy shape on the chart. A one-day surge in realized volatility, on the other hand, is not so much a volatility spike as it is a realized volatility mesa. Realized volatility mesas are shown in Exhibit 14.2.The patterns formed by the gray line in the circled areas of the chart shown below are the result of typical one-day surges in realized volatility.Here, the 30-day realized volatility rose by nearly 20 percentage points, from about 20 percent to about 40 percent, in one day.