I’ve read a few option books.
THANKS... This is probably the most comprehensive "greeks" article/book I’ve read.

Wonderful blog. …..
A wonder wealth of knowledge there. Thanks so much for your kindness in publishing it!

Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

Sunday, May 25, 2008

Volatility Smile and Volatility Skew – Part 3: Why Volatility Smile and Skew Happen

Go Back to Part 2: Understanding Volatility Smile & Volatility Skew

Why Do Volatility Smile & Volatility Skew Happen?

As mentioned in Part 1, in more recent years, Volatility Skew pattern are more commonly observed than Volatility Smile pattern.

For Call options, the Implied Volatility (IV) typically displays a Volatility Skew pattern, whereby IV is the highest for deep ITM options and then is decreasing as it moves towards OTM options.

As discussed earlier, traders/investors are willing to buy an “expensive” deep ITM Calls because they can be used as a leverage tool to gain higher % return with lower capital, as compared to invest in the stock itself. Since deep ITM Calls have delta close to 1, they works like stocks, moving almost dollar for dollar with the stock price, but with much lower capital.
In addition, when extreme price movements are expected, this may also mean that stocks can move sharply to the opposite direction. When the stock prices do not move as expected, ITM options would have lower risk of losing all the money than would ATM and OTM options, due to their inherent intrinsic value.

In contrast, for Put options, the IVs also display a Volatility Skew pattern, whereby IV is the highest for deep OTM options and then is decreasing as it moves towards ITM options.
As mentioned previously, the possible reason why people are willing to buy an “expensive” deep OTM Puts are that probably they are viewed as a form of “insurance” against market crash.
In addition, deep OTM Puts are also considered low cost in terms of dollar; hence this might offer another reason why the deep OTM Puts are quite widely used as an insurance / protection tool of one’s portfolio.

Although Volatility Skew is the typical volatility pattern observed most of the time, sometimes Volatility Smile may appear due to some reasons. And the appearance of Volatility Smile might carry some signals to the market.

Volatility Smiles might indicate that the market is expecting a high possibility of extreme stock price movements as result of either increased volatility in the overall market or in a particular stock.
This might arise in anticipation of corporate news announcements or any pending news that will potentially result in a volatile movement in the stock price.

When big movement in stock price is highly possible, OTM options are more likely to become the ITM options. When this really happens, OTM options will produce higher % return than ATM and ITM would. Moreover, OTM options are lower in terms of dollar. This kind of situations may attract speculators to rush and bet into the market by buying OTM options in order to take advantage of the potential extreme movement in stock price.

Under these circumstances, the speculators would be willing to pay a “higher” price for OTM options as well. This would then drive the price of OTM options upwards through increased IV.
As a result, when plotted into the chart, the IV would show a Volatility Smile pattern, whereby the IVs of both ITM and OTM options are higher (more “expensive”) than the IV of ATM options.

Continue to Part 4: Implications of Volatility Smile & Volatility Skew

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

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