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.

Saturday, June 7, 2008

Volatility Smile and Volatility Skew – Part 4: Implications

Go Back to Part 3: Why Volatility Smile and Skew Happen.

Implications of Volatility Smiles
In some cases, volatility charts of an option may shift over time from Volatility Skew to Volatility Smile, or vice versa.
When volatility charts of a particular stock’s options show a shift from Volatility Skew to Volatility Smile, this may signal an increased speculators’ interest into that stock, implying a possibility of volatile price movements for that stock due to certain reasons. (Please refer to Part 3 for more explanation).
For an options trader, this might offer some trading opportunities in order to take advantage of the potential volatile price movement. For instance, by buying straddle or strangle.

In addition, with the same logic, when an option of a stock displays Volatility Smiles, this stock is expected to be more volatile than a stock that displays a Volatility Skew pattern.
This might also provide some useful information/insight for the traders/investors in their investment decision.

Volatility Smiles and Time Remaining To Expiration
Volatility Smiles seem to be more likely to occur for options with shorter time to expiration.

When extreme price movements are expected to happen for a stock in the near term (which leads to huge interests in speculative trading for that stock), most speculators would more likely choose options with shorter time to expiration.
This makes sense as options with shorter time to expiration are lower in dollar term (as it carries less time value than longer-time-to-expiration options), and hence could potentially provide higher % returns when the extreme price movement does take place as expected.

Therefore, Volatility Smiles may particularly be observed in options nearing to expiration of a stock that is expecting big moves from pending news in the near term, due to heavy speculative trades during that period.

Calculating Estimated Option’s Price Using Options Calculator / Pricer
Since Implied Volatilities vary across different strike prices, it is therefore important to use the respective IV values for a particular strike price when we are calculating an estimated option’s price using options calculator / pricer (e.g. for calculating estimated options price for a stop or price target).
Otherwise, the accuracy of the estimated option’s price will be greatly affected.

Continue to Part 5: Strike Skew vs. Time Skew

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

Related Posts:
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks
* FREE Trading Videos from Famous Trading Gurus

2 comments:

The Dude said...

Hello,

You said "This makes sense as options with shorter time to expiration are lower in dollar term (as it carries less time value) and provide higher delta than longer-time-to-expiration options."

This would be true for ITM options only right?

From "Option Greeks: DELTA (Part 2)"

For ITM options, for the same strike price, the longer days to expiration, the lower the delta. Hence, a next month ITM option will have a lower delta than the current month option.

On the other hand, for OTM options, for the same strike price, the longer days to expiration, the higher the delta. So, a next month OTM option will have higher delta than the current month option.

I'm still a beginner, I could have confused something.

Thanks,
Matt

OPTIONS TRADING BEGINNER said...

Hi Matt,

You're right! Thanks for spotting it. :)

Yes, the higher delta for shorter time to expiration is normally true only for ITM options.

Hence, "higher delta" should not be an important reason why many speculators choose shorter-time-to-expiration options.

I have updated & made some amendments to the post.

Thank you very much for the feedback.
Really appreciate it. :)

Best Regards,
OTB