The Skewed World of Options
The single trading price of a stock is relatively straightforward concept. However, options have many different strike prices that all perform differently relative to one another. A 15 percent out-of-the-money option is far different than an at-the-money option. This difference impacts the way that volatility premiums are calculated and how options perform in real world conditions.
WHAT IS SKEW?
The phenomenon of different strike prices having different implied volatility levels is known as volatility skew. There are many different types of volatility skew, but the most prevalent skew in equity options is investment skew. Explaining the theoretical underpinnings of investment skew, along with its impact on options pricing, could easily fill this entire site. In short, investment skew derives from the fact that most investors are long the market. This results in lower implied volatility levels on strikes that are above the at-the-money strike and higher implied volatility levels on strikes that are below the at-the-money strike.
There are two main factors driving this disparity in volatility levels. The first is because most investors are happier when the market goes up. The profits on their long positions reduce the levels of uncertainty and fear in the market, resulting in lower volatility levels. The reverse is true as the market drops. Investors begin to lose money and their level of fear and uncertainty, or volatility, rises.
SHAPED BY HEDGING
The second driving factor is more complex. Because investors are primarily long the underlying market, the vast majority of their options trades are designed to protect and profit from their long positions. Writing covered calls is the single most popular options strategy. Mutual funds, pension funds, hedge funds and individual investors write millions of calls every day against their long equity positions. This activity tends to depress the values of call options, resulting in lower implied volatility levels on strikes above the at-the-money strike. Another popular options strategy involves purchasing puts to protect portfolios against downturns in the market. This buying activity results in higher prices in put options, and therefore higher implied volatility levels in strikes below the at-the-money strike.
DAZED & CONFUSED?
Skew is perhaps the most misunderstood concept in the options world. Many traders simply cannot wrap their heads around it, resulting in countless trading errors and numerous sleepless nights. I’ve lost count of the number of letters I’ve received from traders & retail customers whose call positions have lost value despite increases in the value of the underlying stock.
While skew is a difficult concept to grasp, it is merely one of many confusing concepts that make up the intricate subject of options volatility. Although this subject can be equally frightening and frustrating, volatility is also the key to understanding the growing world of options. Stay tuned to THE OPTIONS INSIDER.COM for more articles on this alternately fascinating and frustrating topic.
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