Im having trouble intuitively thinking why there is such a marked negative correlation between implied volatility (of a stock option) and the stock price. Does anyone have an intuitive explanation for this?Thanks

stocks : leverage effect + higher probability of negative jumps (which leads to both weaker price and higher vol)indices : same + correlation skew I am more an index guy but fixed strike vol dynamic with spot is far from obvious. Especially when skews are steep, you can underrealise the skew on downside moves. Are you asking about fixed ou floating strike vols ?

Thanks. I am asking about fixed strike vols. The leverage effect seems to not fully explain this effect as seen in this study:http://papers.ssrn.com/sol3/papers.cfm? ... id=256109I sort of understand how the negative jump could affect the vol, but I cant see it being the main reason. If the stock price goes up for a year straight, wouldn't you worry about there being a correction (huge negative jump) in the near future?

"Leverage effect" is just a shorthand phrase for a bunch of bad things happening.Think of a tech firm with no debt (no leverage). But, their customers may be leveraged, their suppliers may be leveraged, and they are operating in a broader economy with lots of leverage everywhere.Their investors may have bought their shares on margins -- whoops, more leverage!Now, suppose the stock of this particular (unleveraged) company drops 50% -- what is a likely scenario thataccompanies it? Maybe we are in a new recession -- well volatilities are generally much higher then forlots of good reasons, inlcuding leverage. Their margined investors are getting margin calls. Theirsuper-leveraged customers (lets say some banks) say we are cancelling our orders, etc. etc. So, since all these effects are well-known, to clear the market, you must build them into option prices. Note that the argument does not imply that options on X, regardless of what X is, must behave this way.If X is not the price of a firm, but say the price of oil, for example, there might be some very nice thingshappening with a 50% drop -- let's say a huge new find. And conversely, some very bad things mightaccompany a 50% rise. So, opposite-sense implied vol. skews can be the rational pattern, too, for some markets.

I don't know the high frequency lead-lag relationship, but at daily frequency the relationship is contempraneous. How do you know that it's the price drop that's causing the increase in vol and not the other way around? Or possibly it could be another factor that's driving the the contempraneous correlation. e.g. if there is a sudden increase in uncertainty about earnings, this will cause an increase in vol and a decrease in price. You'll have strong correlation but not causal link.

My argument doesn't imply a causal link -- it just argues for an negative association between the price and the vol. I said "suppose the stock of this particular (unleveraged) company drops 50% -- what is a likely scenario thataccompanies it?". I could also have said, "suppose the volatility of this particular (unleveraged) company increases 50% -- what is a likely scenario that accompanies it?." Also, I was pretty careful to say 'accompanies' not 'follows'. So, I agree with your point.

The phenomenon that the vol rises before earnings perfectly makes sense to me because the announcement will either cause the price to jump up or down. Still, I dont see why the implied vol should increase if the price of a stock dropped 1%. I do understand the de-leveraging argument for 50% drops, but what about the small drops we encounter often of 0.5-2%, but shouldn't it be a symmetrical effect? And still, why wouldn't an steady increase of a stock price for over six months increase implied volatility? Is this related to the volatility smile?

QuoteOriginally posted by: ChicagoGuyStill, I dont see why the implied vol should increase if the price of a stock dropped 1%. I do understand the de-leveraging argument for 50% drops, but what about the small drops we encounter often of 0.5-2%, but shouldn't it be a symmetrical effect?No - the asymmetry for small local changes is due to the risk premium. You should better ask why big jumps aren't symmetric.QuoteAnd still, why wouldn't an steady increase of a stock price for over six months increase implied volatility?The correlation is for local changes in price due to market inefficiency, not the absolute value of the price. The time locality is because the underlying market conditions change over longer time intervals. QuoteIs this related to the volatility smile?Yes.

Willmotter'sif i mark a vanilla call expiring in april 2010 to market ,where the market is illiquid with an IV of 35,and do the same with a realized daily annualized vol of 19.5 ,can i comfortably say that the MtM for call option based on the IV would be crudely speaking double the MtM of the call option for the RV.cheers.