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How Volatility Selling Boosts Equities

When a participant sells a call or a put, they are taking a short position on volatility, essentially betting that the market won't experience significant fluctuations. This selling tends to occur when there's confidence in the market, usually when participants think the market will go up or after a significant event.


Selling volatility reduces implied volatility (IV), subsequently decreasing the value of options, which prompts increased buying activity in the market.


To explain further; If a participant sells an option the dealer is long that option, the dealer needs to hedge the long volatility risk via buying stocks or futures as the market declines and selling as the market rises. This hedging activity generally reduces realized volatility and supports the 'buy the dip' trade.


The Volatility Risk Premium (VRP) serves as a valuable measure for assessing the potential impact of IV on the underlying.



For example, if the VRP ratio, which measures implied volatility against realized volatility, starts at a higher point, the impact of IV compression is considerably more bullish (more dealer buying). Conversely, when VRP is near/at its lower bound, the effect of IV compression will have less of an impact on the underlying (less dealer buying).


This data is also translated into an easy to read indication on our Key Metrics Table.


Premium: This suggests that implied volatility significantly exceeds realized volatility, indicating that options are overpriced. In such cases, it might be advantageous to sell options or employ spread or ratio strategies for long volatility trades.

This situation amplifies the strength of Vanna flows (Vanna is the sensitivity of an option's delta to changes in implied volatility), serving as either additional 'fuel' for a market rally (if VIX declines) or more of a catalyst for a market downturn (if VIX rises). In such circumstances, traders should closely monitor the VIX.

Discount: This indicates that implied volatility is lower than realized volatility, implying that options are underpriced. In this scenario, there's no 'extra premium' available to collect as a volatility seller. It's generally more favorable to structure trades that benefit from increased volatility.

 

Neutral: This suggests that implied volatility aligns more or less with realized volatility. In this scenario, there's no advantage in terms of short volatility or long volatility strategies.



Advanced Understanding

IV selling and volatility supply, coupled with markets trading higher, results in more dealer exposure to positive Gamma. As participants sell puts and calls, they are betting against market movement and adding negative exposure to Gamma, the dealer is taking on an exposure that makes them money if the market moves (long volatility), all else equal.


To hedge the risk of volatility expansion, the dealer will buy weakness to offset increasing negative Delta (from their long put gaining in value) and sell strength to offset increasing positive Delta (from their long call gaining in value).


These adjustments based on a move in IV is known as ‘vanna’ hedging resulting in vanna flows.


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