Option Price-Volatility Relationship: Avoiding Negative Surprises

A change in implied volatility is typically the culprit when prices seem to have a life of their own even though markets are moving as anticipated. It pays to know more than just the impact of a move on your option’s price whether you’re planning to purchase a put or call option.

Knowing the effect that volatility has on option price behavior can help cushion against losses and it can also add a nice bonus to trades that are winning. The trick is to understand the price-volatility dynamic: the historical relationship between directional changes of the underlying and directional changes in volatility. This relationship in equity markets is easy to understand and quite reliable.

Key Takeaways

• Price charts of the S&P 500 and the implied volatility index (VIX) can indicate that there’s an inverse relationship between option prices and volatility.
• Long puts are affected positively by a fall in the S&P 500 but also by the corresponding rise in implied volatility.
• The premium can decline significantly due to falling levels of implied volatility, counteracting the positive impact of a rise in price.
• You might not receive the profits you were expecting even if you correctly forecast a market rebound and attempt to profit by buying an option.

The Price-Volatility Relationship

A price chart of the S&P 500 and the implied volatility index (VIX) for options that trade on the S&P 500 shows there’s an inverse relationship. Figure 1 demonstrates that when the price of the S&P 500 (the top plot) is moving lower, implied volatility (the lower plot) is moving higher and vice versa.

Figure 1: Daily VIX

The Impacts of Price and Volatility Changes on Options

This table summarizes the important dynamics of this relationship. It indicates with “+” and “-” signs how movement in the underlying and associated movement in implied volatility (IV) each impacts the four types of outright positions.

Two positions have “+/+” in a particular condition. This means they experience a positive impact from both price and volatility changes, making them ideal in that condition. Long puts are affected positively by a fall in the S&P 500 but also from the corresponding rise in implied volatility. Short puts receive a positive impact from both price and volatility with a rise in the S&P 500. This corresponds to a fall in implied volatility.

Table 1: Impact of Price and Volatility Changes on Long and Short Option Positions

The long put and short put experience the worst possible combination of effects in the opposite to their “ideal” conditions, however. This is marked by “-/-“. The positions showing a mixed combination of “+/-” or “-/+” receive a mixed impact. Price movement and changes in implied volatility work in a contradictory fashion. Here is where you’ll find your volatility surprises.

Say a trader feels that the market has declined to a point where it’s oversold and due for at least a counter-trend rally such as in Figure 1 where an arrow points to a rising S&P 500. Depending on how much time has elapsed, a trader may discover that the gains are much smaller or even non-existent after the upward move if they correctly anticipate the turn in market direction and pick a market bottom by purchasing a call option.

Remember from Table 1 that a long call suffers from a fall in implied volatility even though it profits from a rise in price as indicated by “+/-“. And Figure 1 shows that the VIX levels plunge as the market moves higher. Fear is abating and this is reflected in a declining VIX. It leads to falling premium levels even though rising prices are lifting call premium prices.

Long Calls at Market Bottoms Are “Expensive”

The market-bottom call buyer ends up purchasing very “expensive” options in the above example. They’ve effectively already been priced in an upward market move in the above example. The premium can decline dramatically due to the falling levels of implied volatility, counteracting the positive impact of a price rise. This leaves the unsuspecting call buyer miffed over why the price didn’t appreciate as anticipated.

Figures 2 and 3 demonstrate this disappointing dynamic using theoretical prices. There’s profit on this hypothetical out-of-the-money February 1225 long call after a quick move of the underlying up to 1205 from 1185. The move generates a theoretical profit of $1,120.

Figure 2: Long Call Profit/Loss With No Change in Implied Volatility

This profit assumes no change in implied volatility, however. It’s safe to assume when you’re making a speculative call purchase near a market bottom that at least a 3 percentage point drop in implied volatility occurs with a market rebound of 20 points.

Figure 3 shows the outcome after the volatility dimension is added to the model. The profit from the 20-point move is now just $145. The damage is more severe if some time-value decay occurs, indicated by the next lower profit/loss line: T+9 days into the trade.

Important

The profit has turned into losses of about $250 despite the move higher!

Figure 3: Long Call Profit/Loss With Decline by 3 Percentage Points in Implied Volatility

One way to reduce the damage from changes in volatility is to purchase a bull call spread. More aggressive traders might want to establish short puts or put spreads that have a “+,+” relationship with a price rise. A price decline has a “-/-” impact on put sellers, however. The positions will suffer not only from price decline but also from rising implied volatility.

Long Puts at Market Tops Are “Cheap”

Now let’s take a look at the purchase of a long put. Picking a market top by entering a long put option here has an edge over picking a market bottom by entering a long call because long puts have a “+/+” relationship to price/implied volatility changes.

We set up a hypothetical out-of-the-money February 1125 long put in Figures 4 and 5. You can see in Figure 4 that a quick 20-point drop in price to 1165 with no change in implied volatility leads to a profit of $645. This option is more distant from the money so it has a smaller delta leading to a smaller gain with a 20-point move when compared to our hypothetical 1225 call option that’s closer to the money.

Figure 4: Long Put Profit/Loss With No Change in Implied Volatility

Figure 5: Long Put Profit/Loss With Rise in Implied Volatility by 3 Percentage Points

Figure 5 shows a rise in implied volatility by three percentage points. Profit now increases to $1,470 and it’s nearly $1,000 even with the decay of time value occurring at T+9 days into the trade.

Speculating on market declines and trying to pick a top by purchasing put options therefore has a built-in implied volatility edge. What makes this strategy more attractive is that implied volatility is typically at extreme lows at market tops so a put buyer would be buying very “cheap” options that don’t have too much volatility risk embodied in their prices.

What Is Implied Volatility?

Volatility is a measure of how much a price moves up or down over a cited period. Implied volatility is a best guess as to the volatility of a stock at a future date. It can be highly susceptible to current events and internal company factors. Anticipation of an event or announcement can increase it. Time passing beyond the event or announcement can decrease it.

How Long Has the S&P 500 Been Around to Monitor Prices?

The S&P 500 premiered in 1923 on a much smaller scale. It was called the Composite Index back then. It tracks about 500 publicly traded U.S. companies as of 2024.

What Is Time Value?

Time value is the segment of a premium that can be affected by future events up until the option expires. It’s what remains after intrinsic value is subtracted. Buyers are willing to pay for it because they expect the premium to increase.

The Bottom Line

You might not receive the profits you were expecting even if you correctly forecast a market rebound and attempt to profit by buying an option. The fall in implied volatility at market rebounds can cause negative surprises by counteracting the positive impact of a rise in price.

Buying puts at market tops has the potential to provide some positive surprises as falling prices push implied volatility levels higher, however. This adds additional potential profit to a long put that’s bought very “cheaply.” Being aware of the price-volatility dynamic and its relation to your option position can significantly affect your trading performance.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.