Traders are either confused or don’t know much about the ‘Volatility skew’. The Volatility skew was not a prominent subject, at least three decades back. The volatility skew is best defined as the difference in Implied or IV, between OTM, ATM and ITM options. Here, OTM stands for ‘out of the money’ options, ATM stands for ‘at the money options’, and ITM stands for ‘in the money’ options. Volatility skew is affected by a number of factors, including demand and supply relation and sentiment. It offers great information for money managers, who take decisions related to writing calls or puts. Some traders also call it the vertical skew.
Understanding the volatility smile
The volatility smile is defined as a pattern, in which the ‘at the money options’ trend to have lower implied volatility than ITM or OTM options. Please note that the volatility smile can be different in different markets. Currently, the volatility smile is highly skewed. Graphically, this is represented to demonstrate the IV of a set of options. The volatility skew is measured for options that have the same strike price and expiration date, although options with different dates can be used at times. When the IV is plotted against the strike price, the curve looked like a U or a smile, and that’s where you get the term ‘volatility smile’.
You can search online to find more details about the stock market crash of 1987. Something unusual happened to option prices on Oct 19, 1987. Back then, OTM options were considered to be more inexpensive, mainly with regards to dollars per contract. OTM options were more attractive for buyers, and risk takers were more interested in selling it. Since the number of sellers was lesser than buyers for OTP calls and puts, the prices were higher than normal. However, after that day, OTM put options emerged as a more attractive option for buyers. These puts also worked like insurance for the portfolio, keeping the next debacle in consideration. As result, the volatility knew replaced the volatility smile.
It is not hard to understand the Volatility skew. Just look at the IV data of the concerned option chain. Of course, there is no denying that this concept is often hard to explain. The skew can be useful in understanding strategies under certain market conditions. You can check online to know the history and other aspects that will eventually matter in the future.
Author Bio: Kim Klaiman is a blogger on money, finance and everything else related to this segment. She is also a part-time trader and has worked with many blogs as a guest author.