Many options traders have no idea how much volatility changes can impact their positions – even more than changes in the underlying’s price. This post continues a blog series on volatility in options trading, answering a reader’s question about bear put spreads.

Welcome back to my series on volatility in options trading. Today’s post continues the theme with a great question from TradeKing client jayvee53. He writes:

“You state in the bearish long put spread, if the bearish forecast is right, the trade benefits from lower IV and if the forecast is wrong, the trade would benefit from higher IV. Isn't there an inverse relationship between price and IV, meaning if the price of the underlying goes down (the bearish forecast was right) IV would be going up?

Then, in the case of an incorrect bearish forecast, we would be looking for higher IV to help our cause, but because the underlying is going up, IV would be expected to be going down.  

Seems to me we would not expect IV to be moving in the direction we would like to see it in these examples.  Have I got this wrong?”

Hello Jayvee53,

The concept you highlight (implied volatility’s inverse relationship to price) is a good talking point. You can make some general inferences that, more times than not, if the stock price increases, IV will decrease, and if the stock price decreases the IV will increase.

There are many exceptions to this rule, and one of them is when movement is centered around an event like an earnings announcement. After an earnings announcement it is very possible for the stock to go down and the implied volatility to drop also.

That said, if you assume the inverse relationship concept holds true most of the time, it may influence which strategy you choose to implement. If you’re bearish, you might just buy a put outright instead of doing the bear spread. A long put would like IV to increase, so if your bearish forecast is correct and the IV does increase this would be beneficial to the position. It’s worth reading up on puts and volatility to learn more about this phenomenon.

In my post on Volatility and Calendar Spreads (Part 2), we have a Google example around an earnings event. The stock dropped 12 points, but IV went down with it, and that IV drop affected the bottom line quite a bit when it was all said and done.  

Once again, it does depend on your forecast for the underlying and the level of bearishness you feel for a stock. Bottom line, understanding how volatility affects the ins and outs of a strategy is very useful when picking your strategy and approach to the trade.

Two final caveats to keep in mind. First, spreads are multiple leg option strategies that involve additional risks and multiple commissions, and may result in complex tax treatments. Be sure to consult with your tax advisor before engaging in these strategies. Second, while implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.


Just tuning in? Previous volatility posts in this series

My first post outlined 3 key volatility terms: implied versus historical volatility and vega, the Greek measuring volatility’s affect on an option’s price. Post 2, Volatility: When Vega Trumps Delta, explained how volatility crunch preys on long options. Post 3 dealt with volatility and long call spreads, and post 4 moved on to volatility and short call spreads.

I dealt with calendar spreads next in two posts. Post 5 explains how, despite many traders’ expectations, calendars don’t benefit from super-low volatility. Post 6 described a phenomenon known as volatility tilt that can affect calendars around earnings season.

Post 7 dealt with position vega, plus I offered a free Options Playbook to the first reader to ask the pop-quiz correctly. Post 8 announces the winner and why his answer was correct.


Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

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