Event volatility, also known as "event IV," refers to the increased implied volatility (IV) that occurs around important market events. Implied volatility represents the expected range in the underlying asset based on options pricing. During days when significant events are scheduled for a specific security or the overall market, IV tends to rise above its average levels.
These events can include earnings announcements, economic calendar events like CPI, FOMC, or geopolitical events such as major elections or conflicts. Because of the increased uncertainty surrounding these events, options are traded at higher prices. This higher pricing reflects the market's anticipation of increased price movements or uncertainty during these periods.
For example, in the days leading up to the May 1, 2024 FOMC and May 3, 2024 NFP, the SPX was pricing in a 1-Day implied move of 0.80%. However, on the day the event, the market experienced increases levels of implied volatility, with a 1-Day implied move of 1.0% or greater resulting in higher priced options in relative volatility terms.
Volatility Crush (IV Crush)
Implied volatility (IV) and options premiums often undergo a phenomenon known as IV crush following an event, where the prices of options decrease significantly. This often occurs because options prices were initially inflated and not justified. This can negatively affect those who purchased long options at elevated IV; therefore, structuring long volatility trades via spreads (bull call/bear put) can lessen the impact of volatility crush.
Traders can capitalize on the subsequent decrease in event volatility by selling premium before the event occurs or slightly after the occurrence, presenting an opportunity for profit. It is important to note that short options strategies during these periods carry significant tail risk, potentially leading to devastating outcomes. Therefore, it is wise to limit position sizes, utilize spreads, and implement stop limits to effectively manage potential risks.
Forecasting Realized Volatility
In quantitative analysis, when forecasting realized volatility (the actual observed price movements based on historical data), it is common to exclude days with known event volatility from the calculation. This exclusion helps prevent artificially inflating the forecasted volatility figures. Including event volatility in the calculations can cause a deceptive and sudden shift in moving averages, known as windowing. By excluding event volatility from the time series, the moving averages remain consistent and reliable.
Understanding Implied Volatility During Major Events
Uncertainty - The increased uncertainty around these events leads to higher risk. This higher risk leads to market participants being more uncertain of the outcome and the potential consequences, thus driving implied volatility higher.
Market Reactions - Market participants closely monitor these high volatility events. This anticipation of potential market reactions changes supply and demand dynamics for options which contribute to the increased volatility. Prior and post the event it forces participants to adjust their positions and hedges by buying or selling options, which often results in 'whipsaw' type action.
Liquidity Concerns - During periods of heightened volatility, market liquidity can become thinner. This reduction in liquidity can exacerbate price movements, leading to larger swings and less predictability. Some market participants, such as institutional investors or large market-making firms (dealers), may reduce their trading activities during events that carry higher uncertainty or potential volatility.
Option Pricing Dynamic - Implied volatility is a crucial component in options pricing. As implied volatility changes dealers need to adjust their hedges because with higher volatility, delta can change more rapidly. This can exacerbate price swings in the market. In simple terms, when implied volatility expands, dealers tend to sell, and when implied volatility contracts, dealers tend to buy.
Information Flow - Events like NFP, CPI, FOMC, Earnings provide new information about the state of the economy, monetary policy and inflation. This new information can bolster or challenge existing narratives and market expectations leading to participants and dealers adjusting their outlook and trading strategies.
Wider Bid-Ask Spreads - During these high vol events dealers may widen the bid-ask spreads. This further reduces liquidity thus increasing the risk of slippage and cost to participate making it more challenging to get filled at desired prices. Dealers incur costs in providing liquidity and facilitating transactions therefore they will widen the spread to incorporate these costs and ensure they are compensated for the service they provide. This larger spread allows dealers to capture a higher portion of each trade's value as profit, leading to greater compensation for their services.
In summary, Implied Volatility plays a major role in options pricing and should not be overlooked when deciding to participate in markets and determining how to structure your options trade.