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

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Good Reading Links

Good readings for trading education:

Vix & More: What Is High Implied Volatility?

The Stock Bandit: Stop Loss Discussion

The Stock Bandit: Trading Video - Tips on Trading Breakouts

Ray Baros: Thinking ‘Three Moves Ahead’ IV

Read More

What To Consider When You Are Buying An Overpriced (High IV) Options

In the previous post, we discussed that when IV is relatively low (option is cheap) and is expected to rise, we should buy options (i.e. consider options strategies that allow us to be an option buyer).
On the other hand, when IV is relatively high (option is expensive) and is expected to drop, we should sell options (i.e. consider options strategies that allow us to be an option seller).

However, often we’d like buy options despite the relatively high IV (i.e. options is considered expensive).
For example, for myself, I like playing directional swing trading to take advantage the expected price movement for 1 – 3 days. Hence, in this case, I’ll just buy straight call or put options depending on the expected direction. However, frequently the option is relatively high in IV (“expensive”). Is it all right if I buy the options?
To me, buying options when IV is high is still all right.
However, there are a few things to consider when buying options with high IV:

1) As mentioned earlier, usually IV is high because we're expecting certain events that can cause the drastic price movement (e.g. earnings announcement, FDA approval, M&A, etc.). Before that event happens, the IV normally will not drop drastically, and is also quite likely to rise even higher and peak on the day of the event itself.
So, if I'd like to play swing trading or day trading, I have to make sure that I close my position (sell the options) before the event take places.

2) Assess the Reward / Risk ratio of a potential trade by having different scenarios of IVs, expected / target stock prices & time remaining to expiration (using Options Calculator / Pricer).
By inputting different IV numbers (e.g. the highs, lows, or average, etc.) as a parameter in the Options Calculator / Pricer, you can see how IV can potentially affect your trade under different scenarios.
This could also help you to assess whether it’s better to use ITM (In-The-Money), ATM (At-The-Money), or OTM (Out-of-The-Money) options.
As discussed previously on more understanding about IV, ATM and OTM options are more affected by IV movement than ITM options.

(You can refer to the link for more discussion on how to get IV data)

3) Some traders like to bet with options over the events that can cause the drastic price movement (e.g. earnings announcement, FDA approval, M&A, etc.).
In this case, we have to bear in mind that some degree of price movement has been priced in with the high IV. So, when IV drops considerably right after the announcement, we can only gain if the price movement is big enough to offset the drop in IV. Otherwise, we'll lose money with options even though the stock price moves to the expected direction.
(As discussed more detail in this post).

4) When IV is relatively expensive and you don’t want your options to be affected too much by the IV changes, you may want to consider buying further ITM (In-The-Money) options.
Remember that IV has a considerable effect on the option price, but it affects only the time value component of an option's price, not on the Intrinsic Value
(Please refer to this post: More Understanding About Implied Volatility).
Therefore, the deeper ITM options will be less affected by the changes in IV, as it has less time value component in the option price. The further ITM an option, the lesser time value component it has.

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

Read More