IV Responses to Large Daily Moves
IV Responses to Large Daily Moves
By:Kai Zeng
Don't let market stability make you complacent with your portfolio
- Implied volatility was remarkably stable in 2023.
- Despite the prevailing optimism, it is imperative for traders to remain vigilant.
- An unforeseen market reversal could trigger a significant increase in implied volatility.
Last year was a remarkable period for bullish traders, with the market exhibiting an impressive resilience.
Implied volatility, a measure of the market's expectation of the potential range of an asset's price movement, has been remarkably stable. In fact, this year is on record as the third tightest in terms of implied volatility since the tumultuous days of 2008.
S&P 500 has been remarkably stable
The S&P 500 Index (SPY) had only one instance of a daily move exceeding 2% in either direction last year—a stark contrast to the historical norm. That underscores the stability investors have seen in the market.
This low-volatility environment has instilled a sense of confidence among traders, as evidenced by multiple sectors reaching new heights.
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Don't let your guard down
Despite the prevailing optimism, it is imperative for traders to remain vigilant about the potential for downturns. This is especially true for options traders, for whom implied volatility levels are a cornerstone of trading strategy. The question arises: should the market dip by 1% or 2%, how might this affect the implied volatility?
To address this query, we conducted an analysis examining the relationship between the daily percentage changes in major market indices—the SPY, NASDAQ 100 (QQQ), Russell 2000 (IWM), and Dow Jones Industrial Average (DIA)—and their corresponding implied volatilities from 2005 to the present.
The findings were telling: the SPY was most sensitive to a 1% or 2% downturn in terms of implied volatility response, while the IWM was the least reactive. This information is critical for traders as it highlights the differing levels of risk associated with each index.
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Furthermore, in a low-volatility environment, any unforeseen market reversal could trigger a significant increase in implied volatility.
On the other hand, in 2022, the implied volatility was less responsive to underlying price declines compared to previous years, as it was already at an elevated level. Traders should be prepared for such scenarios where the market's complacency could be shattered, leading to a rapid recalibration of price expectations.
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In conclusion, while the current market conditions seem favorable, traders must stay attuned to the subtle dynamics of implied volatility. The SPY's heightened sensitivity to price decreases and the potential for abrupt increases in implied volatility in a quiet market underscores the need for a strategic approach.
Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1
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