Volatility Skew Definition:
Using the Black Scholes option pricing model, we can compute the volatility of the underlying by plugging in the market prices for the options. Theoretically, for options with the same expiration date, we expect the implied volatility to be the same regardless of which strike price we use. However, in reality, the IV we get is different across the various strikes. This disparity is known as the volatility skew.
If you plot the implied volatilities (IV) against the strike prices, you might get the following U-shaped curve resembling a smile. Hence, this particular volatility skew pattern is better known as the volatility smile.
The volatility smile skew pattern is commonly seen in near-term equity options and options in the forex market.
Volatility smiles tell us that demand is greater for options that are in-the-money or out-of-the-money.
A more common skew pattern is the reverse skew or volatility smirk. The reverse skew pattern typically appears for longer term equity options and index options.
In the reverse skew pattern, the IV for options at the lower strikes are higher than the IV at higher strikes. The reverse skew pattern suggests that in-the-money calls and out-of-the-money puts are more expensive compared to out-of-the-money calls and in-the-money puts.
The popular explanation for the manifestation of the reverse volatility skew is that investors are generally worried about market crashes and buy puts for protection. One piece of evidence supporting this argument is the fact that the reverse skew did not show up for equity options until after the Crash of 1987.
Another possible explanation is that in-the-money calls have become popular alternatives to outright stock purchases as they offer leverage and hence increased ROI. This leads to greater demands for in-the-money calls and therefore increased IV at the lower strikes.
The other variant of the volatility smirk is the forward skew. In the forward skew pattern, the IV for options at the lower strikes are lower than the IV at higher strikes. This suggests that out-of-the-money calls and in-the-money puts are in greater demand compared to in-the-money calls and out-of-the-money puts.
The forward skew pattern is common for options in the commodities market. When supply is tight, businesses would rather pay more to secure supply than to risk supply disruption. For example, if weather reports indicates a heightened possibility of an impending frost, fear of supply disruption will cause businesses to drive up demand for out-of-the-money calls for the affected crops.
Your new trading account is immediately funded with $5,000 of virtual money which you can use to test out your trading strategies using OptionHouse's virtual trading platform without risking hard-earned money.
Once you start trading for real, your first 100 trades will be commission-free! (Make sure you click thru the link below and quote the promo code '60FREE' during sign-up)Click here to open a trading account at OptionsHouse.com now!
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®.... [Read on...]
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]