variations in supply and demand might also require market makers to
change the volatility variable in order to ensure liquid markets. In these
circumstances, the customer brings his or her anticipation of a change in
price to the market and buys or sells accordingly: The market maker recognizes
the importance of responding to or capitalizing on these changes.
The market maker is not changing volatility on an option contract based
on his expectation of a news event; rather, he or she is changing volatility
based on the public's expectation of an event that will possibly affect the
value of an option.
Depending on how a particular option exchange is structured, market
makers and/or a specialist are charged with providing liquidity to the
markets. For each option on each stock for which they make the market,
these floor traders establish two prices: the bid and the offer. The bid is
the price at which they will purchase that option, and the offer (sometimes
referred to as the ask or asking price) is the price at which they will
sell that option. The difference between the bid and offer prices, known as
the spread, is limited in size by regulation. When supply and demand for
options are in balance (that is, when there are approximately as many
buyers as there are sellers), market makers act as middlemen-collecting
the spread as they buy at the bid price from the sellers and sell at the
offer price to the buyers. At these times, they collect their profit without
assuming much risk.
These conditions are infrequent, however, due to a typically one-sided
order flow in option markets. Usually, most customers want to either purchase
options or sell options. If all of the customers are purchasing
options, the option market makers are selling. We refer to this situation
as one-sided order flow. In a two-sided order flow situation, customers are
buying and selling. Two-sided order flow is generally more common in
larger issues that have greater volume. Again, for most option market
makers, however, two-sided order flow is rare.
Given a typically one-sided market, market makers are obligated
(albeit reluctantly) to create the balance. In other words, when there are
more sellers, the market makers become buyers. Then, market makers
are like merchants who have an inventory ofproducts that are not selling.
Also, because of their role, the market makers must continue to buy.
When this situation happens, they invariably lower their prices for the
option. They will continue to lower their prices as long as the imbalance
continues.
When there are more buyers, the floor traders accumulate not only
inventory but also risk. Under these circumstances, floor traders will
increase their prices in an effort to reduce further buying or to provide a
larger cushion against their increased risk. At these times of imbalance
between option demand and supply; an option's implied volatility can vary
dramatically from any notion of a reasonable forecast volatility. The market
is not really adjusting volatility; rather, it is adjusting prices in order
to reflect changed market conditions. Volatility, however, is the pricing
variable that absorbs this change.
In terms ofthe increase in demand for options, consider the increased
demand during earnings months when investors enter the options marketplace
in order to speculate on the earnings of a particular underlying
issue. As large buy orders continue to enter the trading pit, the floor
traders continually increase the price (as explained earlier). This price
increase produces an increase in the implied volatility. Continued buying
by the public under these circumstances means that the public is willing
to pay more for the perceived opportunity of making money on a large
earnings move in the underlying issue. Other events that might increase
the demand for options include takeover rumors, earnings releases, and
other news announcements.
Conversely, if there is a large supply of a particular class or type of
option, prices will decrease resulting from a corresponding decrease in the
volatility variable. After the earnings have been announced, for example,
option-implied volatility will generally revert to more normal levels as
orders come in to sell options. The unknown is now known, and the speculators
are now selling the options that they purchased. Clearly, the old
adage, "Buy the rumor, sell the news" is true when evaluating volatility.
The excess demand now becomes the source of an excess supply. Again,
the increased selling will cause the floor traders to lower their prices by a
decrease in volatility.
Read More: Factors Influencing Implied Volatility
