• “HAPPY BIRTHDAY TO SKEW!” —you gifted
songwriters can fill in the rest. You have till
October, but if you want to start planning now to
celebrate the birth of one of our favorite trading
concepts, know that the crash of 1987 introduced implied volatility (IV) skew.
Before that, it was assumed options could be
priced with a single volatility (vol). So if the SPX
was at $300, the theoretical value of the $280
put used the same vol input, say 35%, as the $320
call. On Black Monday, the market dropped
more than anyone imagined it might. From that
point on, the market valued puts (protection) as
being worth a lot more than before.
NO LONGER SINGLE
On October 20, the market was pushing up
the prices of out-of-the-money (OTM) puts
because people were either hedging against, or
speculating on, another big drop. That drove
the IVs of those puts higher than
equidistant OTM calls. Remem-
ber that IV is the volatility input
for a theoretical option pricing
model that makes the theoretical
option value equal to the option’s
market price. In practice, when
the option’s market price goes up,
When the market price of an option drops, so
does its IV.
With vol skew, the IV of that $280 put might
be 40%. And the IV of the $320 call might be
30%. The phenomenon of di;erent IVs at di;erent strike prices creates skew. For stocks and equity indices, skew is usually steeper toward the
puts, whose IVs are higher than calls because
the equity market typically fears a big drop more
than it expects a big rally. For physical commodities, the skew can be steeper toward the calls,
whose IV is higher than puts because the market fears a big price increase if there’s a shortage
in that physical commodity.
You can explore volatility skew in two places on the thinkorswim® platform from TD
Ameritrade. On the Trade page, go to the Option Chain to load up the “Impl Vol” column
for the actual IV numbers. Or find the Product
Depth and set “Value” to “Impl Vol” to get
the skew’s graphic representation. Notice the
shape of the skew looks like a smile.
THE SMILE SAYS IT ALL
VOL WHISPERER ; PRO
IN THE MONEY
BIG IDEA: THIS THING CALLED SKEW;WHAT IS IT? WHY
DOES IT EXIST? AND HOW CAN YOU INTERPRET IT?