A volatility smile is defined as 'a long-observed pattern in which ATM options tend to have lower IV (implied volatility) than in- or out-of-the-money options. The pattern displays different characteristics for different markets and results from the probability of extreme moves'
image courtesy of investorglossary.com
In other words, black swan events occur more often than predicted by mathematical models, and far OTM options trade with a higher implied volatility than ATM options.
In today's world, this volatility smile is so skewed to the downside that the IV of OTM puts is significantly higher than that of ATM options, which in turn have higher IV than OTM calls. This is considered as rational in light of the 'frequent' market crashes. Frequent is defined as far more often than any mathematical model would have predicted.
Kurtosis is the mathematical term used to recognize that not all tails of the curve are created eual and that market crashes are far more common than market surges. Thus, PUT IV exceeds call IV.
The early texts could not mention 'volatility skew' and many of us 'grew up' in the options business with no understanding of the importance of volatility skew. I now shudder to recall that one of my favorite strategies (late 70s and early 80s) was to own ratio spreads in which I would buy one put with a higher delta and sell 2 or 3 times as many puts with a lower delta. I thought I was capturing theoretical edge by selling puts with a higher implied volatility. Today, if anyone were to use that ratio strategy, it would not be to capture edge. It would be more of a bet on where the market is headed next.
Volatility skew is easy to notice. All one has to do is look at IV data for any option chain. Nevertheless, the concept has often proven difficult to explain.
When teaching traders who have not yet discovered the importance of volatility skew, the skew can be used to explain why one specific strategy is more profitable under certain market condition that others. This is an important topic for future discussion.
Mark Sebastian at Optionpit.com suggests one good method for following the volatility skew for a specific underlying asset. It takes a bit of work, but owning a good picture of skew, as it changes over time, is probably worth the small amount of time that it takes to track the data.
How does one find volatility skew?
Is this accomplished by studying the matrix with implied volatility and comparing daily I.V.? By finding richer condors?
Every stock has volatility skew. Some will be steeper than others. The best way to track skew is by looking at the volatility of several options with a specific delta. You keep track of the skew by charting the changes in the volatility of these specific delta options and the spreads between them.
For instance, one might want to keep track of the 5 delta put, the 20 delta put, the 50 delta call, the 25 delta call, and the 10 delta call. Why these options? I think using these options can give a fairly accurate representation of the skew curve. After picking your options, keep track of the volatility, but more importantly, the volatility spreads from strike to strike and option to option. Put them into excel, and fill it in every day. Run a graph over the vols and you will really be able to see the skew curve. Run a second graph over the differences in the vol spread, and you will really be able to see how the curve is moving.
Generally, when we get to about 15 days to expiration, I like to switch to the next month out. Here’s a nice reminder to switch, when you hit the first of the month, you should no longer be using that month to chart skew. In your charts, make sure to note when you switch months. You will actually begin to notice patterns in how the skew curve moves.
As far as condors, those are a good indicator that something is happening, and maybe a very quick short cut. However, it’s not a wonderful way to really track skew.
Sebastian also makes the important point that it's not a good idea to constantly trade the same strategy, using the same underlying, month after month (Guilty. I'm a RUT iron condor trader.) Instead volatility skew, among other factors, should be considered. Iron condors work well when skew is steep and less well when skew is flatter.
Obviously this discussion is incomplete, but just knowing that volatility skew exists and that it can help a trader get better results, makes it a topic that we should all want to understand.
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