Halloween is time of the year that many Americans celebrate and embrace “fear.” In 2018, traders have been unceremoniously pulled into the party, due to some steep selloffs in asset prices.
If you are looking to better understand the dynamics of market fear, a recent episode of Options Jive rates as "must-see TV.” The show focuses on the the flow of fear when it enters the market, particularly as it relates to heightened implied volatility, and where it spreads across the time horizon.
Taking a step back, imagine the price of implied volatility for next week, versus next month, and next year. The further we go out on the time horizon, the less certain we are of what might occur. Because of this reality, implied volatility in the future tends to be priced "richer" than that of shorter time horizons.
The question asked by the Options Jive team relates to the behavior of implied volatility when uncertainty picks up in the current moment (i.e. the correction observed in October 2018).
Thinking logically, one might assume that because the distant future is already a big unknown, it remains that way. In turn, that also could mean an increase in uncertainty in the present moment might have a greater effect on shorter-duration volatility.
Based on the research presented on Options Jive, this does appear to be the case.
The slide below depicts the averages for implied volatility in the VIX across a range of expirations going back to 2011. Notice how shorter-term durations have lower implied volatility on average as compared to longer-term durations - matching our original hypothesis:
Now, let's take a look at a snapshot of the same data, but this time just a single day - when volatility was spiking. The image below shows how implied volatility was priced on October 22, 2018, amidst the selloff:
The above provides empirical support for our earlier thought that increasing “fear” in the immediate moment has a bigger impact on the price of risk in the near-term, as compared to the longer-term.
Visualizing the “flow of fear” in this fashion, may help you better conceptualize what’s happening the next time fear grips the market (or even amidst the current carnage, which may not be over).
This episode of Options Jive also highlights another key piece of research. Based on data revealed on the show, one can see that when volatility does spike, it tends to rise at a much faster rate than it falls. Rationally, this makes sense because the onset of “fear” is typically sudden. On the other hand, it can take longer to “come down” after a big shock.
For a full breakdown of all the material presented on the show, we hope you’ll take the time to watch the complete episode of Options Jive focusing on “fear in the markets” when your schedule allows.
We also recommend checking out a new episode of Market Measures called “Only Trade in High IV?” This episode compares trading in all environments versus only trading when implied volatility has risen dramatically.
One part of the analysis even looks at why “doubling down” in high IV environments hasn’t historically produced superior results as compared to taking a methodical, balanced approach to short volatility positions through “all markets.”
Both episodes highlighted in this blog post may help you refine your approach to trading in high volatility environments.
As always, we hope you’ll reach out with any questions or comments - by leaving a message in the space below, or contacting us at @tastytrade on Twitter or by sending us an email at firstname.lastname@example.org.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.