The successful option trader must know not only how a change within the underlying stock or index will impact on position profitability, but also how time and a change in implied volatility will affect the position. Time moves predictably in one direction and its effect is straightforward to predict with an easy option price calculator. Volatility on the opposite hand is complex and fewer easy to forecast. there’s however an anecdotally described relationship, with solid empirical data to support it that in 30 years academics haven’t been ready to adequately explain. This relationship, once understood by option traders and assimilated into their option trading strategies will provide them a sustainable trading edge.
One of the foremost enduring empirical regularities in equity markets is that the inverse relationship between stock prices and volatility. This was first documented by Black in 1976 who attributed it to a relationship called the ‘Leverage Effect’. Simply put, for a corporation funded by a mixture of debt plus equity, because the share price falls, the debt remains constant and therefore the equity falls, and this induces a better equity-return volatility.
Academics in additional recent times have tried to prove the Leverage Effect by comparing the share price to volatility relationship for all-equity companies with debt-equity companies. they need not been ready to prove the existence of the Leverage Effect. Instead, the finance theoreticians have named this relationship the ‘Down Market Effect.’ the teachers explain the inverse relationship between share market performance and implied volatility may be a combination of time-varying risk premiums and cognitive mechanisms of risk perception – or more simply that traders and investors have a lower appetite for risk during a falling market than a rising one. The Down Market Effect are often observed when share prices fall, realised and implied volatility increase. My very own testing suggests implied volatility is more aware of share prices than realised volatility. That is, check about it on http://www.nas100brokers.com/strategy.html that implied volatility relationship overreacts to a move within the underlying index.