Options Trading: Strategy Intensive Nuances of the Implied Volatility Skew

Options Trading: Strategy Intensive
Nuances of the Implied Volatility Skew

Over 2 Hours of RiskDoctor options trading training covering chapter 10 of Options Trading: The Hidden Reality.

Definitions and what others say about Skews and Implied Volatility Smiles

Q: What is Volatility Skew?

A: Volatility Skew is the difference in the Implied Volatility between out of the money calls and out of the money puts. Typically Implied volatilities across different strikes exhibits what traders refer to as a "smile", i.e. out of the money options have slightly higher volatilities than at the money options. But sometimes the "smile" is "skewed", i.e. equally out of the money calls and puts differ in their Implied Volatility. The skew thus represents the markets bias towards calls or puts. In iVolatility.com we show the skew as the ratio of Call volatility to Put volatility. Therefore, a number greater than 100% means Calls are priced higher than Puts and vice versa. This shows that the market has a positive bias towards the upside, while if this number is less than 100% then puts are being valued higher. Very high skew numbers could suggest a strong bias in the view of the market's opinion of the stock. For example, if the skew suddenly drops, it could suggest that there is a rumor afloat and the market is getting nervous about the downside of a stock and thus loading up on puts and selling calls.

To finish our discussion, let's take a closer look at IV by examining what is known as a volatility skew. Exhibit 1 below contains a classic July cotton call options skew. The IV for calls increases as the option strikes get farther away from the money (as seen in the northeasterly, upward sloping shape of the skew, which forms a smile, or smirk shape). This tells us that the farther away from the money the call option strike is, the greater the IV is in that particular option strike. The levels of volatility are plotted along the vertical axis. As you can see, the deep out-of-the-money calls are extremely inflated (IV > 42%). July Cotton Calls - Implied Volatility Skew July Cotton Calls - IV Skew

Exhibit 1 Created using OptiExhibit 2 onVue 5 Options Analysis Software

The data for each of the call strikes displayed above in the Exhibit 1 is contained in Exhibit 2 above. When we move farther away from the at-the-money call strikes for the July calls, IV increases from 31.8% (just out of the money) at the 38 strike to 42.3% for the July 60 strike (deep out of the money). In other words, the July call strikes that are farther away from the money have more IV than those nearer to the money. By selling the higher implied volatility options and buying lower implied volatility options, a trader can profit if the IV skew eventually flattens out. This can happen even with no directional moves of the underlying futures.

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