I’ve read a few option books.
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Saturday, May 10, 2008

Volatility Smile and Volatility Skew – Part 1: Description

Previously, we’ve talked a bit about Volatility Smile and Volatility Skew in this article.

Basically, Volatility Smile and Volatility Skew show that even for the same expiration month, Implied Volatilities (IVs) can vary by strike price.
We can get Volatility Smile or Volatility Skew charts by plotting the IV values of options for the same expiration month across various strike prices.

For some options, given the same expiration month, the IVs of In-The-Money (ITM) & Out-of-The-Money (OTM) options are higher At-The-Money (ATM) options.
As a result, when the IVs for various strike prices are plotted into a chart, it would take shape approximately like a U-pattern, which is by glance, it looks like a smile.
As such, this kind of chart is often known as “Volatility Smile”.

Some options may have higher IV for more ITM options, and then is decreasing as it moves towards OTM options.
On the other hand, other options might have higher IV for more OTM options, and then is declining as it goes towards ITM options. Such patterns are often called “Volatility Skew”.



In one paper on “Volatility Smile”, Don Chance suggested that the relationship between Implied Volatility and Option’s Strike Price has been documented since at the least the 1987 market crash.

When first observed, the relationship between the two variables took shape as a Volatility Smile. However, in more recent years, the Volatility Smiles have mostly disappeared, and Volatility Skews are more commonly observed.

The typical volatility patterns observed recently are as follow:

For Call options, the Implied Volatility is typically the highest for deep ITM options and then is decreasing as it moves towards OTM options.

For Put options, the Implied Volatility is typically the highest for deep OTM options and then is decreasing as it moves towards ITM options.

In other words, generally the “most expensive” options are deep ITM Calls and deep OTM Puts.

As to the reasons why certain options are “more expensive” than the others, Don Chance said that actually no one really knows.

For Put options, the possible reason why people are willing to buy an “expensive” deep OTM Puts are that they are viewed as a form of “insurance” against market crash. The lower cost in terms of dollar might also offer another reason for deep OTM Puts to serve as an insurance / protection tool of one’s portfolio.

For Call options, the possible reason why traders/investors are willing to buy an “expensive” deep ITM Calls are that they can be used as a leverage tool to gain higher % return with lower capital rather than to invest in the stock itself. Because deep ITM Calls have delta close to 1 and hence it works like stocks, moving almost dollar for dollar with the stock price, but with much lower capital.

Continue to Part 2: More Understanding of Volatility Smile & Volatility Skew

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

Related Topics:
* FREE Trading Educational Resources You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns

3 comments:

Tony Chai said...

Hi OTB :

Always nice to learn new things from
your options articles web-site.

Keep up the great work.

Regards,

Tony Chai

OPTIONS TRADING BEGINNER said...

Thanks for the kind words, Tony. :)
I also hope this can benefit many people.

Regards,
OTB

karl k said...

One of the reasons that the volatility "smile" (nice and even on both sides of the ITM strikes) has evolved into a volatility "smirk" OTM put with much higher implied vols) is the fact that markets never "crash up."

Declines in general happen more quickly and more precipitously than rallies.

Interestingly, currency options tend to smile more than smirk. Index and equity options in contrast are smirking at you and me.