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Sunday, June 29, 2008

“Deeper OTM Puts are considered as ‘most expensive’ options”: What Does This Really Mean?

In my post “Volatility Smile and Volatility Skew – Part 1”, it is mentioned as follows:

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.

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.


As discussed earlier in this link, an option is deemed cheap or expensive not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is expensive, whereas when the IV is relatively low, the option is considered cheap.

For deep ITM Calls, even without understanding the above concepts, people won’t really question why they are deemed “most expensive”, as the options premiums are also higher in terms of dollar.
However, for deep OTM Puts, those who are not aware the above concepts will be wondering why deep OTM Puts is considered “most expensive”, as the options premiums are actually low in terms of dollar value.

In this post, we’ll focus on discussing OTM Puts, by comparing less-deeper and deeper OTM Puts.

As deeper OTM Puts normally have higher IV than less-deeper OTM Puts, deeper OTM Puts are therefore considered as "more expensive".
However, this does not mean that the premium of deeper OTM Puts will be higher in terms of dollar.

This is because an option's premium is affected by 6 factors, not only IV.
As discussed in the previous post (i.e. Options Pricing), other important factors that determine option’s price are option’s strike price & current stock price.

Although deeper OTM Puts is higher in IV (and hence it's considered "more expensive"), their option premium will be lower in terms of dollar than less-deeper OTM Put options.This is because deeper OTM Put options' strike prices will be much farther from the current stock price, as compared to less-deeper OTM Puts would.
As a result, deeper OTM Put options will have much lesser chance / probability (almost no chance) of becoming “In-The-Money (ITM)” before expiration. Or in other words, it is almost certain that the deep OTM options will not finish ITM.

Remember that for OTM options, option premium will only consist of Time Value component.
(Please see this post – Option Price Components – in case you need more clarification).

As previously mentioned in this post (More Understanding about Options Time Value):

Time value can be viewed as “the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish In-The-Money (ITM)”.
The more uncertain, the higher the time value will be.


An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.

Hence, in this case, higher IV increases the time value of deeper OTM Puts. However their overall premium will be lower than less-deeper OTM Put options in terms of dollar, particularly because of lower uncertainty (almost no chance) of the deeper OTM Puts to finish ITM before expiration, as they have farther option’s strike price from current stock price.

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

Related Topics:
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks

Sunday, June 15, 2008

Volatility Smile and Volatility Skew – Part 5: Strike Skew vs. Time Skew

Go Back to Part 4: Volatility Smile and Skew Implications

Strike Skew vs. Time Skew
Actually, there are 2 types of volatility skews: Strike Skew and Time Skew.

1) Strike Skew, or sometimes called Vertical Skew, is obtained by plotting Implied Volatility of an option with the same expiration month across various strike prices.
This is the most common type of Volatility Skew.
The volatility skew that has been discussed so far in the previous posts is Strike Skew.

2) Time Skew, or sometimes called Horizontal Skew, is obtained by plotting Implied Volatility of an option with the same strike price across various expiration months.
This kind of volatility skew might be seen as an indicative of market’s future expectations on a stock.

Generally speaking, it is possible for options with any expiration month to have higher IV levels than options with the other expiration months.
Because this volatility skew is mainly driven by expected price movement surrounding an impending news event that may significantly affect the stock price.
These skews can arise and disappear as the news event approaches and then passes.

Nevertheless, the typical time skew pattern observed is higher IV for options with shorter time to expiration than for longer-time-to-expiration options.
One possible reason is that most speculators are probably more interested in betting on “surprises” that are expected to occur in shorter term than those in longer term.
As such, they would also prefer options with shorter time to expiration, as these options are lower in terms of dollar value (as it carries less time value than longer-time-to-expiration options), and hence can potentially provide higher % returns when the extreme price movement does take place as expected.
This would consequently increase demand for shorter time options, and hence push the options’ price up through higher IV.

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

Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks

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