Volatility: The Rules by David Merkel, CFA of Aleph Blog
Rapid upward moves in volatility almost always presage a bounce rally.
Again, I am scraping the bottom of the barrel, but this is a common aspect of markets. When things get tough, scaredy-cats buy put options. That pushes up option implied volatilities. The same doesn’t happen when prices are rising, because that happens slower. Prices fall twice as fast as they rise in the stock market.
Emotions play a big role with options, and many do not use them rationally. Rather than using them when the market is rising in order to hedge, more commonly they hedge after the market has fallen.
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As implied volatility rises, the ability to make money from hedging falls, as the cost of insurance goes up. As a result, hedging peters out, and the market will be receptive to positive news, given that most who want to hedge have hedged. Their pseudo-selling is over, and a bounce rally will happen.
Volatility tends to mean-revert, and as the reversion from high levels of volatility happens, the value of stocks rise. People buy equities as fears dissipate.
Volatility, both actual and implied, are tools to have in your arsenal to help you understand when markets might be overvalued (low volatility) or undervalued (very high volatility). Use this knowledge to guide your portfolio positioning. At present, it is more reliable then many other measures of the market.
Next time, I end this series. Till then.