put/call skew on broad-based indexes

loufah · Sep 21, 2005

With near the money options, puts usually have a higher extrinsic value than calls - greater risk of a sudden drop, upcoming dividend, etc.

But I'm seeing the opposite on SPY and QQQQ right now. For instance, with SPY at 120.95, the Oct 119 C is $3.20x$3.30 and the Oct 124 P is $3.20x$3.40, about the same price. The Oct 125 P, which I traded today, had a bid that was just a couple pennies above intrinsic value. There's a rich premium (sic - I mean in the "paying more than its value" sense) for the call and practically no premium for the put. If you look at options a couple points deeper, the extrinsic value of calls seems to be $.50 to $.70 more than that of the equidistant put. Why is this?

zf trader · Sep 21, 2005

I could answer this for you but not with the elegance of coach Phil.(thanks for all the help in the past)

Deringer · Sep 21, 2005

Out of the money puts have more value than out of the money calls for the SPs and Qs. Since in the money calls are really synthetics for out of the money puts, and in the money puts are synthetics for out of the money calls, those in the money calls should have higher extrinsic value than the in the money puts. There's nothing weird with those prices. IOW, the Oct 119 levels have a higher implied volatility than the Oct 124 levels.

Quote from loufah:

With near the money options, puts usually have a higher extrinsic value than calls - greater risk of a sudden drop, upcoming dividend, etc.

But I'm seeing the opposite on SPY and QQQQ right now. For instance, with SPY at 120.95, the Oct 119 C is $3.20x$3.30 and the Oct 124 P is $3.20x$3.40, about the same price. The Oct 125 P, which I traded today, had a bid that was just a couple pennies above intrinsic value. There's a rich premium (sic - I mean in the "paying more than its value" sense) for the call and practically no premium for the put. If you look at options a couple points deeper, the extrinsic value of calls seems to be $.50 to $.70 more than that of the equidistant put. Why is this?

smilingsynic · Sep 21, 2005

Quote from Deringer:

Out of the money puts have more value than out of the money calls for the SPs and Qs. Since in the money calls are really synthetics for out of the money puts, and in the money puts are synthetics for out of the money calls, those in the money calls should have higher extrinsic value than the in the money puts. There's nothing weird with those prices. IOW, the Oct 119 levels have a higher implied volatility than the Oct 124 levels.

There is negative skew for all stock indices (and, generally, for stocks too). The OTM puts (and, hence, the ITM calls) have traded at a higher IV since the 1987 crash. Funds used to buy "portfolio insurance" (selling futures to make up for losses on stocks) but they now buy otm options. More demand for the options, acc to basic economics, means a higher price, hence the skew.

The deeper OTM the put (ITM the call), the more pronounced the skew.

Deringer · Sep 22, 2005

Quote from smilingsynic:

There is negative skew for all stock indices (and, generally, for stocks too). The OTM puts (and, hence, the ITM calls) have traded at a higher IV since the 1987 crash. Funds used to buy "portfolio insurance" (selling futures to make up for losses on stocks) but they now buy otm options. More demand for the options, acc to basic economics, means a higher price, hence the skew.

The deeper OTM the put (ITM the call), the more pronounced the skew.

The put skew is there in place to protect the downside. That's why it's been in place since th 1987 crash to prevent events like that. If there are huge gaps in the market, it's more likely that it will be on the downside than the upside. People should understand that OTM puts have value.

jim c · Sep 22, 2005

Quote from Deringer:

The put skew is there in place to protect the downside. That's why it's been in place since th 1987 crash to prevent events like that. If there are huge gaps in the market, it's more likely that it will be on the downside than the upside. People should understand that OTM puts have value.

I always thought this was the case as well. However I find the same type of skew exists with eurodollars and bonds/notes. How can this be? Jim

sle · Sep 22, 2005

Quote from jim c:

I always thought this was the case as well. However I find the same type of skew exists with eurodollars and bonds/notes. How can this be? Jim

There is a big difference between skew and smile, one is caused by market's perception of process (i.e. normal or lognormal or something in between) vs smile, which is caused by vol-of-vol/gap premium in the vols. This said, the skew in rates market is usually driven by the fact that rates process is somewhere between normal and CIR, rather then pure lognormal. Look at the thread about smile modelling for more info. In addition, there is some smile in there too.

ps. I hate the new Bloomberg keyboard .

Deringer · Sep 22, 2005

Quote from jim c:

I always thought this was the case as well. However I find the same type of skew exists with eurodollars and bonds/notes. How can this be? Jim

That's the result of the interest rate bias. If the bias was for the other direction, you would see a different type of skew. But right now, rates are very unlikely to fall back down anytime soon, so some strikes just aren't in demand.

smilingsynic · Sep 22, 2005

Quote from Deringer:

The put skew is there in place to protect the downside. That's why it's been in place since th 1987 crash to prevent events like that. If there are huge gaps in the market, it's more likely that it will be on the downside than the upside. People should understand that OTM puts have value.

Likewise, physical commodities like beans and oil have positive skew, since gaps are more likely to be on the upside.

Deringer · Sep 22, 2005

Quote from smilingsynic:

Likewise, physical commodities like beans and oil have positive skew, since gaps are more likely to be on the upside.

Yes, that's pretty common for grain markets, metal markets, and most soft commodities. If USDA guarantees farmers a specific price floor, then it decreases the probability that the commodity will trade below that floor, so those otm put strikes would not be in high demand.

However, I think it also really depends on where the commodity is currently trading because crops tend to be seasonal, and if the crop has already risen quite a bit and is already near the upper range, then the otm puts up to a certain point would create more interest. Perhaps the best way for anyone to really understand the skew bias is to fully understand the market environment and the pricing tendencies of that market.