Question about (Strike Price) Implied Volatility Skew

[TradingDemystified]

Hello everybody, first time poster here.

I have a conceptual question for option traders specialized in Volatility Skew.

If we take a look at any index product (or their ETFs) a noticeable skew is observed on the downside. For example, looking at OTM puts as of today (for the May 19th expiration, 46 days away) for SPY

SPY=235.33

Strike Price ----- Implied Volatility (based on OTM Puts)

210 ----- 19.09%
215 ----- 17.16%
220 ----- 15.21%
225 ----- 13.27%
230 ----- 11.31%
235 ----- 9.29% <---- This is the ATM

My question here is, assuming there is a violent move to the downside where SPY goes to 220. Intuitively there would be an increase in Implied Volatility across the board for all strikes (let's forget about Horizontal/Time Skew for this example). One would think that IV would rise for the 220 Strike put. However, since it already started with an elevated IV (because of skew), any increase due to price movement to the downside would be countered by the fact that 220 is the new ATM and therefore the (theoretical) lowest IV for that series.

I guess my question here is conceptually, is the skew a sort of "look into the future" of what the IV would be if the underlying were to reach that point?

Does the underlying crashing change the shape of the vertical skew? And if designing strategies counting on IV increase for OTM puts, wouldn't that be negated by the already elevated level at which they start and the subsequent shift in the price structure (being the new ATM)?

 

[stepandfetchit]

You may consider plotting SKEW alongside VIX thru some more sizable VIX spikes, which may shed some light! -- Below is a 3yr daily chart of VIX with SKEW overlaid in green.

SKEW often, but not always returns to it's normal range after a large VIX increase! (SKEW Y axis on left side)

 

[sonoma]

I have a conceptual question for option traders specialized in Volatility Skew.

I guess my question here is conceptually, is the skew a sort of "look into the future" of what the IV would be if the underlying were to reach that point? [/I]

•• If the move is "violent," then local iv will tend to sticky strike-or greater-behavior. If the move is gradual, then local iv will tend to sticky delta behavior. There have been a variety of attempts to model changes in strip vol with price movement. Index trades.

Does the underlying crashing change the shape of the vertical skew?

•• Yes. In general, the skew steepens as realized vol starts to exceed implied.

And if designing strategies counting on IV increase for OTM puts, wouldn't that be negated by the already elevated level at which they start and the subsequent shift in the price structure (being the new ATM)?

•• Yes, it can.

•• Derman wrote a number of monographs for Goldman many years ago, some publicly available, some not. It's worth looking for those, if you've got any deeper interest in this topic. There are some nuggets hidden in there, depending on your needs. There are, of course, traditional academic papers on the same.

 

[sle]

I guess my question here is conceptually, is the skew a sort of "look into the future" of what the IV would be if the underlying were to reach that point?

As a general idea, the skew is form of risk premium - you are paying more for the expectation that realized or implied volatility will be higher along this particular path.

And if designing strategies counting on IV increase for OTM puts, wouldn't that be negated by the already elevated level at which they start and the subsequent shift in the price structure (being the new ATM)?

Well, no - just like any other risk premium strategy, you are saying that this particular risk premium is mis-priced (rich or cheap, that's up to you).

I think I wrote a long skew trading post a few years ago, too lazy to look at it right now.

 

[TradingDemystified]

As a general idea, the skew is form of risk premium - you are paying more for the expectation that realized or implied volatility will be higher along this particular path.


Well, no - just like any other risk premium strategy, you are saying that this particular risk premium is mis-priced (rich or cheap, that's up to you).

I think I wrote a long skew trading post a few years ago, too lazy to look at it right now.

I will look it up... your posts are always informative and well thought out (although a bit over my head sometimes

 

[sle]

I will look it up... your posts are always informative and well thought out (although a bit over my head sometimes

"Do or do not! There is no try!"

So, homework assignment. Take you favorite underlying, say AAPL. Let's say you

• bought a 25d put and sold a 25d call (both 1 month),
  
• sizes are calculation for position to be Delta and Gamma neutral on day one.

Now, take the Greeks for that position and move the spot price around by some meaningful amount

• how do your exposures change as the underlying moves up or down?
  
• what are the sources of PnL as the market is moving one way or the other?
  
• what exposure factors appear to be missing producing "unexpected" P&L?

 

[Robert Morse]

I recorded the SPY option skew on LVX. I want to post this in this thread:

Bob

 

[tommcginnis]

The farther from the money you go, the greater the difference a nickel (or similarly small increment in price) will mean. As that happens, pricing in general goes from being a comparatively continuous function (mathematically) to an increasingly step-wise and *lumpy* function. With that, where does the lumpiness get made up? With the pricing-*implied* volatility -- the "IV".

And the more that the strikes get into nickels and dimes, the more the IV will go up.

 

[sle]

similarly small increment in price

You do realize that only retail is constrained by the listed increments in the option prices? When a hedge fund calls the dealer desk, they would frequently quote in small increments - then exchange print would still be kosher by fudging the price of the delta.

 

[tommcginnis]

You do realize that only retail is constrained by the listed increments in the option prices? When a hedge fund calls the dealer desk, they would frequently quote in small increments - then exchange print would still be kosher by fudging the price of the delta.

Killjoy.