One of the fun aspects of writing a blog and communicating with investors is the opportunity to answer questions. Some questions are very sophisticated, while others are basic. It's those basic questions that require the most attention because the questioner is likely to be a rookie who is caught in a situation he/she does not understand. If that rookie cannot be guided through this difficult spot, it's possible that he/she may throw up hands in disgust and abandon options.
That's the reason I pay special attention to questions to which the answer may seem obvious. It's not obvious to the person who poses the question.
I recently found this question at EliteTrader, an online forum.
"When call IV (implied volatility) drops does that mean options traders are getting bearish on the stock?"
What I don't know is what situation made the poster ask this question. But that's no reason not to provide a useful reply.
Answer: No. Implied volatility, by itself, is not an indicator of market sentiment. NOTE: It does not matter whether call IV declines or put IV declines. As soon as one declines, the other follows suit. That's the result of arbitrage strategies (reversal/conversion). If call prices decline, those arbitrageurs will buy calls, short stock, and then drive down the price of puts by selling them.
When implied volatility declines for the options of a specific stock or index, it can suggest one of a few alternatives, but market direction is not one of them:
a) Buying interest has declined. That means fewer traders want to buy the options, and there is no force driving option prices (and implied volatility) higher.
b) Selling interest has increased. The quickest way to drive down option prices is for sellers to appear on the scene. That does not mean call sellers or put sellers. In fact, it makes no difference which options are sold. If there is selling pressure on the options, prices decline.
You may ask how can it not make any difference whether traders are selling puts or calls. The answer is that to the professionals who provide liquidity – from the market makers to the off-the-floor traders sitting behind computer screens, an option is an option and it makes no difference whether it's a put or a call.
Why? If a trader buys calls, he/she has two choices: Keep the calls, or turn them into synthetic puts by selling 100 shares of stock for each call purchased. Thus, in this case, a call is readily converted into a put. That's another way to state that calls are puts.
If the trader buys puts, the purchase of 100 shares per put changes those puts into synthetic calls. Thus, puts are calls.
As a result, declining call IV produces the same result as declining put IV and as mentioned above, if the IV of the puts does not drop automatically (after call prices decline), arbs will appear on the scene to remedy any imbalance.
c) If IV is elevated because of a pending news announcement [That news has a good chance of causing the stock price to gap, and that possibility makes options worth more money, and IV rises], once the news is released and a major move is no longer in the future (it has already occurred after the news was released), there is no longer any reason to bid option prices higher. Thus IV falls (for both puts and calls). Again, it has nothing to do with market direction.