The Relationship Between IV in Volatility Products | Market Measures

Jan 6, 2016

By: Sage Anderson

While some market participants are likely slowly getting back in the swing of things, the tastytrade research team is charging hard into the new year.

The research guys recently introduced an interesting perspective with their Market Measures episode "IV of Volatility Products" - a no-nonsense examination of why relationships between implied volatility (IV) and an underlying are so different in volatility-based products as compared to traditional stocks.

As most tastytraders will likely already be well aware, a stock's price and associated implied volatility tend to move inversely.

The chart below illustrates this phenomenon very clearly in the S&P 500:

IV_VolProducts_Market Measures

However, when looking at products that track volatility, the exact opposite relationship can be observed. In so-called "volatility products" (i.e. VXX), implied volatility generally moves in the same direction as the underlying.

The graphic below shows the correlated relationship between volatility products and their implied volatility:

IV_Vol_same relationship_Market Measures

In the case of stocks, it makes sense that a rise in the underlying would theoretically result in a reduction of IV (especially on average, over time). As stocks rise, especially if the pace is on the slow side, fear typically subsides and risk premiums decline.

On the other hand, a rise in VXX means that uncertainty is increasing, which in turn inflates the implied volatility of the volatility product's options.

This somewhat unorthodox relationship means that when traders deploy complex positions in volatility products they need to be cognizant of the risk exposure they are actually holding.

For example, getting long puts in a traditional stock would usually garner rich rewards when volatility increases (i.e. VIX goes up). Contrarily, in the VIX, a trader that buys puts is hoping for the opposite - a contraction in volatility.

The hosts of this particular episode of Market Measures, Tom Preston and Tony Battista, delve into much greater detail on the episode in regards to how traders can leverage this new understanding of volatility-based products and implied volatility in their own portfolios.

We invite you to watch the Market Measures episode for the full rundown of this topic when your schedule allows.

If you have any questions or feedback on today's post we encourage you to contact us at support@tastytrade.com

We look forward to hearing from you!

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.

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