Volatility rising much ahead of elections over the years; why and what does it mean for traders

The market's forecast of a security's price movement is known as implied volatility.

Market expectation of volatility ahead of election —as measured by implied volatility (IV)—has been rising earlier over the years.  A high IV suggests the market expects significant price fluctuations, while a low IV suggests the opposite. Also, higher the IV, greater the options.

In 2014, IV started rising 22 days before the election; in 2019, it was 35 days prior. This year, it started inching higher late February onwards, a good 55 days before the election results.

Chart showing IVP change year to date| Source: Quantsapp

Chart showing slow and steady rise in implied volatility for Nifty 50 index ahead of elections | Source: Bloomberg

What has changed is that the rise in IV has become less sharp.

This can be seen from the historical Implied Volatility Percentage (IVP) figure. This  measures the number of days current IV has exceeded those respective days’ IV, divided by the total number of observed days (ideally 250).

Volatility has been making headlines of late, especially with investors cashing out after India VIX shot up to 18 on May 9 from a low of 10 on April 24. Since then, the Nifty has tumbled from its peak of over 22,700 to May 9’s level of 21,900.

Question is: How does this slow but steady rise, instead of a sudden jump in IV, affect the options market?

1. Anomaly traders, the term for those looking to benefit from short-lived market inefficiencies, do not get to make huge gains by buying options. When IV is high, options are more expensive because there's a higher likelihood of big price swings, which could lead to bigger gains (or losses) for option holders.

2. As people are getting ready for the event (elections), the increase in IV (Implied Volatility) because of the event isn't very big. The effects of the event are being factored into prices ahead of time.

3. A slow and steady rise in IV bodes well for option writers, as premiums remain stable and there is less possibility of sudden negative surprises.

“For the last 2-3 years, we have seen a trend of IV rise going down compared to earlier.,” derivatives trader Santosh Pasi told moneycontrol.

“The low volatility is because currently we have more option sellers in the market, due to less margin requirements for the spreads and more algo-based trading. Hopefully, as we progress towards counting day, it will rise," he said.

Pasi is navigating the current market by using credit spreads and event strategies to be deployed.

The market's forecast of a security's price movement is known as implied volatility. IV is frequently used to price options contracts where high implied volatility leads to higher premiums for options and vice versa. The primary influencing elements for estimating implied volatility are supply and demand and temporal value.

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