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Learn About Volatility Skew

Sebencapital

Published
22/12/23
Learn About Volatility Skew

Volatility skew in options trading means that options with the same expiration but different strike prices have varying levels of implied volatility (IV). It looks at how IV differs for in-the-money, at-the-money, and out-of-the-money options.

Implied volatility measures uncertainty linked to an option's underlying stock and how it changes at different option trading prices. It shows the market's belief about the likelihood of the underlying asset reaching a certain price. In-the-money, at-the-money, and out-of-the-money refer to the options' strike price concerning the current market price of the asset.

Watching volatility skew is important for option traders because higher implied volatility reflects increased uncertainty about the underlying stock.

The Volatility Smile

When options first traded on an exchange, the situation with volatility skew was different. Out-of-the-money options often traded at higher prices compared to their value. This led to what's known as a "volatility smile" on price charts, where implied volatility for puts and calls increased as the strike price moved away from the stock's current price.

After the stock market crash in October 1987, a shift occurred in option prices. Out-of-the-money options, which used to be relatively cheap per contract, became more expensive. Previously, these options were more appealing for buyers than sellers because they often ended up worthless at expiration.

Due to this, the supply for these options was less than the demand, causing their prices to rise higher than usual. This situation is similar to other areas of trading where prices increase when there are fewer sellers compared to buyers.

The Effects of "Black Monday"

Since the stock market crash in 1987, out-of-the-money (OTM) put options have become more appealing to buyers due to the potential for significant profits and as a safeguard against market downturns. This increased interest in put options has caused their prices, measured by implied volatility (IV), to remain higher compared to OTM call options. This change led to what is now known as the "volatility skew."

This shift in preference has resulted in a persistent pattern where OTM puts, which have strike prices below the stock's current price, show higher implied volatility. Conversely, OTM calls, with strike prices above the stock's price, demonstrate lower implied volatility. This volatility skew has replaced the previously observed "volatility smile" in the options market.

Note

When the strike price and expiration date are the same, both call and put options have the same implied volatility (IV). Even though this might not be immediately clear by just looking at the options prices, paired put and call options share a common IV.

Sure, here's a simplified and SEO-friendly version:

"Some investors and money managers aim to avoid future bear markets by using put options for protection. This creates a consistent demand for put options.

In the financial markets, the Implied Volatility (IV) tends to go up when the market goes down and decreases when the market goes up. When markets decline, people tend to get worried and buy more put options or stop selling them. This increased demand or reduced availability of put options leads to higher prices. Essentially, when there's fear of a market drop, put option prices rise due to more buyers or fewer sellers."

(FAQs)

How do you trade using the volatility skew?

Certainly, here's a simplified and SEO-friendly version:
"Checking volatility skew helps find options with high or low premiums. This matters a lot for traders who use spreads – they sell one contract to balance the cost of another.
For instance, a trader who's optimistic about a company can use volatility skew to pick the right contracts for a strategy like a bull put spread."

Why is volatility skew steeper for options that expire in the near term?

"As an option gets closer to its expiration date, it requires more volatility for the stock to reach strike prices that are 'out of the money' (OTM). This leads to an increase in Implied Volatility (IV) because the stock needs to move further and faster to hit the OTM strike before expiration.
On the other hand, when an option has more time until expiration, it doesn't need to move as quickly. This results in a decrease in IV compared to options with shorter durations."

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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