Determining Implied Volatility Skew

Implied volatility skew refers to the uneven distribution of implied volatility levels across different strike prices of options with the same expiration date. It indicates a deviation from the assumption that implied volatility remains constant across all strike prices.

In most cases, implied volatility skew is observed in equity options, particularly in options on individual stocks. The skew is characterized by higher implied volatility levels for out-of-the-money (OTM) options compared to at-the-money (ATM) or in-the-money (ITM) options. This means that market participants are willing to pay relatively higher premiums for options that are further out of the money, indicating a perceived higher likelihood of significant price moves in those directions.

Reasons For Volatility Skew

There are a few reasons for the existence of implied volatility skew:

  • Protective Puts: Skew is partly influenced by the demand for protective puts. Investors who hold long positions in stocks may purchase OTM put options to protect against potential downside risk. This increased demand for OTM puts drives up their implied volatility levels.
  • Market Perceptions: The skew also reflects market participants’ perceptions of the risk associated with different strike prices. OTM options are considered riskier and more prone to larger price swings, leading to higher implied volatility. On the other hand, ATM and ITM options are perceived to have relatively lower volatility expectations.
  • Supply and Demand Dynamics: Implied volatility skew can be influenced by supply and demand dynamics in the options market. For example, if there is a significant demand for downside protection due to negative news or market sentiment, it can drive up implied volatility for OTM put options.
  • Market Dislocations: In certain market conditions, such as during earnings announcements or other significant events, implied volatility skew can become more pronounced. This can be due to specific risks or uncertainties associated with the underlying stock.

It’s important to note that implied volatility skew is not present in all markets or for all underlying assets. It is more commonly observed in equity options due to the specific factors mentioned above. Skew can also vary over time as market conditions change.

Traders and investors should be aware of implied volatility skew when evaluating options strategies. The choice of strike prices and understanding the relative implied volatility levels can impact the pricing and risk considerations of options positions. Analyzing and monitoring implied volatility skew can provide insights into market sentiment and potential trading opportunities.

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