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Volatility Skew- Understanding Option Premiums Over Different Time Frames and Strikes

In covered call writing, our option premiums are influenced by the volatility of the underlying security. Using the Black Scholes option pricing model, we can calculate the volatility of the underlying by entering the market prices for the options. Common sense would seem to dictate that for options with the same expiration date, we expect the implied volatility (IV) to be the same regardless of which strike price we use. However, in reality, the IV we see is different across the various strikes. This disparity is known as the volatility skew. Let’s first review some key definitions:

Implied Volatility- This is a forecast of the underlying stock’s volatility as implied by the option’s price in the marketplace. This differs from historical volatility:

Historical volatility: This is the actual price fluctuation as observed over a period of time.

As discussed in my books and DVDs, an options pricing model such as the Black-Scholes model uses six inputs to determine the theoretical price of an option:

  • asset value
  • time left until expiration
  • strike price
  • risk-free interest rate
  • dividends (if applicable)
  • *asset volatility

Option premiums will rise and fall with volatility. These pricing models make the incorrect assumption that volatility is constant throughout each respective strike price and regardless of duration. Supply and demand will never allow these conditions to exist. It is, however, possible to calculate IV for different strike prices and over different time frames by using the current options price as a given, using the other five inputs listed above and then solving for that specific IV. The difference in implied volatility levels for options with the same underlying security is known as volatility skew.  Stated differently, it is the difference in IV between out-of-the-money, at-the-money and in-the-money options and also different expiration periods.

Types of Skews

1- Vertical Skews (different strike prices):

The two types of vertical skews are forward and reverse. The reverse skew which is common to the equity market is where the lower option strikes have higher IVs and the higher strikes have lower IVs.  The downside options are being priced more aggressively to put more premium on fast downward moves, which intuitively makes sense. If we plotted the IVs over the various strike prices, here is what a typical skew chart would look like:

Skew chart for strike prices and IV

Horizontal skews (same strike, different expirations):

Horizontal skew refers to the situation where at a given strike price, IV will either increase or decrease as the expiration month moves forward into the future. A forward horizontal skew occurs when volatilities increase from near to far months.   This is typical of the equity market. A reverse horizontal skew occurs when volatilities decrease from near to far months. Below is a chart showing a forward horizontal skew for the S&P 500:

Forward horizontal skew

 

Skew smirks and smiles

Although volatility skew (see the top chart) is most typical for equity strike price, we occasionally see a volatility smile or smirk. This could occur when there is anticipation of extreme market or stock price movement like an earnings report or other corporate news. This can result in speculators buying the out-of-the-money options to take advantage of the potential price movement. As a result the IV of the higher strikes will rise thereby changing the skew to a smile or smirk pattern as shown in the images below:

Implied volatility over different strikes

Classic Volatility Smile Pattern

Volatility smiles and smirks

In these instances the I-T-M and O-T-M strikes have higher IVs (more expensive) than the A-T-M strikes.

Sites to build skew charts

Free:

http://www.optionistics.com/f/volatility_skew

 

Not free but sophisticated:

www.livevol.com

 

Conclusions

By studying the IV chart patterns we know that the volatility assumptions made by option pricing models rarely exist in the real world. IVs ARE different across different strikes and time frames. Generally the market assigns a higher IV for lower strikes and higher IVs for longer durations for the same strikes. These typical stock IV patterns result in skew patterns. When a skew develops into a smile there is an expectation of greater price movement in the future causing the chart pattern to turn up into a smirk or smile. Some sophisticated options traders will trade with or against the skew. That discussion is beyond the scope of this site. For our community of Blue Collar Investors we use our knowledge of skew and smile patterns to better understand the relationship between IV and our option premiums and to red flag potential risk in the future.

Recent addition to our live seminar presentations:

Saturday June 8, 2013: Baltimore, MD- details to follow

Market tone:

Unfortunately, my concern for disappointing earnings has come to fruition, influencing the market despite some decent economic reports:

  • For the third straight month, retail sales rose 1.1% in September beating expectations by 0.3%
  • The Consumer Price Index (CPI A widely followed indicator of inflation. The CPI is a measure of the average change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. The “core” CPI excludes food and energy prices, which account for roughly one-quarter of the broad CPI and tend to fluctuate widely, providing a truer reflection of inflationary trends) increased 0.6% in September
  • The “core” CPI rose just 0.1%. Both rates are within the Federal reserve’s “comfort zone”
  • Construction of new residential homes rose an impressive 15% in September, the highest level since mid-2008 
  • Multi-family construction rose by 25%
  • September’s existing homes sales came in at 475,000, 1.7% lower than August but 11% higher than a year ago
  • National median existing-home price was 183,000 in September, up 11.3% from a year ago
  • Output for factories, mines and utilities rose by 0.4% in September, more than anticipated
  • Business inventories rose by 0.6% in August indicating that businesses are keeping pace with rising retail sales
  • The Conference Board’s index of leading economic indicators rose in September by 0.6%, better than anticipated

For the week, the S&P 500 rose 0.3% for a year-to-date return of 16%, including dividends.

Summary:

IBD: Market in correction

BCI: Neutral, favoring in-the-money strikes. This may be a month to keep some cash on the sidelines, favor ETFs or low-beta stocks and in-the-money strikes. This site believes the negative tone is short-term.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written three top selling books on the topic of selling covered calls alone. He is a dentist by day, a personal trainer, successful real estate investor, but he is known mostly for his profound stock option strategies.

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13 Responses to “Volatility Skew- Understanding Option Premiums Over Different Time Frames and Strikes”

  1. Alan Ellman October 20, 2012 3:33 pm #

    Weeklys/Ellman Calculator:

    I had an offsite question as to whether The Ellman Calculator can be used for weeeklys. The answer is yes because the calculation is annualized based on the expiration date. In the screenshot below (single tab) we show the calculations for two weeklys for QQQ. The 1-week and annualized returns are highlighted in yellow. CLICK ON IMAGE TO ENLARGE AND USE THE BACK ARROW TO RETURN TO BLOG.

    Alan

  2. Barry B October 20, 2012 4:57 pm #

    Premium Members,

    The Weekly Report for 10-19-12 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since Earnings Season is in full swing right now, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The BCI Team

  3. Barry B October 20, 2012 5:15 pm #

    Premium Members,

    One of the stocks on the Premium Report this week, V, has Weekly Options for those of you who have a higher risk tolerance. However, please remember that because of the short duration of these options, you will not be able to effectively use Alan’s Exit Strategies.

    Best,

    Barry

  4. Gene Montavon October 21, 2012 10:28 pm #

    Great introduction on IV and Skew. I understand that the BCI methodology mitigates alot of risk inherent in options trading. Based on the article above regarding Skew do we need to incorporate any type of process outside the BCI methodology that would include us now checking the skew on any possible covered call positions before actually selling a contract? We are already checking for earnings reports, would this additional step benefit us?

    I do appreciate your reply.

    • Alan Ellman October 22, 2012 11:10 am #

      Gene,

      Glad you like the article. You DO NOT need to take any additional steps outside of the methodology described in my books and DVDs. You are 100% spot on when you say that the system mitigates much (but not all) of the inherent risk in trading options. I have been writing weekly articles for five years now and the ideas come from my team and I partially but mainly from you, our members. This site is here for us to learn from each other and the more educated we are, the closer we are to becoming “CEO of our own money” and ultimately financially independent. Understanding why the IV of options on the same stock can vary from strike to strike and expiration to expiration is important but does not require us to take any additional steps in the BCI methodology for cc writing.

      Alan

  5. Alan Ellman October 22, 2012 12:39 pm #

    ENHANCED SEARCH TOOL FOR BCI SITE:

    We have added a google plug in to enhance the quality of your searches in our BCI site. See the screenshot below found on our blog page. (click to enlarge, use the back arrow to return to blog):

    Alan and the BCI team

  6. Stan October 24, 2012 9:47 am #

    Alan,

    Can you explain the difference between a married put and a protective put. Thank you.

    Stan

    • Alan Ellman October 24, 2012 1:20 pm #

      Stan,

      A married put is exactly the same as a protective put except for the time when the underlying security was purchased. A married put and the stock are purchased at the same time.

      Alan

  7. Linda October 24, 2012 12:53 pm #

    THank you for the work and education that is ongoing!
    Couple of questions:
    You have some basic rules to follow, depending on our risk etc. Yet many times you have on your premium list options with a large spread over (1-2 or more $$$ over) the .30 suggested spread. Why are they on the premium list.
    THere are also several stocks tht do not have the suggested 250,000 volume that your rules recommend.
    Wondering why these are continuously on the premium list.
    Thank you
    Linda

    • Barry B October 24, 2012 6:00 pm #

      Hello Linda,

      Per your questions…
      [1] We do not screen for bid/ask spread. Alan’s $0.30 spread is only a guideline to help you choose among potential trade candidates. The Bid/Ask Spread tends to be a moving target that is influenced by many factors. If, in fact, you find a stock that you like, but the spread is greater than $0.30, you can try to “negotiate” the Bid/Asked Spread. This topic was covered in one of Alan’s recent blog articles. The link to the article is:
      http://www.thebluecollarinvestor.com/playing-the-bid-ask-spread-when-selling-covered-call-options/

      [2] As for your volume question…we screen for average volume over the past 50 trading days to be >250,000 shares per day. This is to insure that there is decent liquidity. I went back and checked all of the stocks that passed this week and were on the Running List, and every stock had an average volume greater than 250,000 shares per day. It is possible that on a given day, the volume may be lower than 250,000 shares per day. The average volume per day is actually the very first item that gets screened each week.

      I hope that this answered your questions…if not, please post and I’ll get your questions answered.

      Best,

      Barry

      • Steve Z October 26, 2012 5:11 pm #

        Barry, I know Linda’s question was about volume, but as long as we look at the bid-ask spread, isn’t Open Interest really more important for us than volume? How would you answer if her question was about putting stocks on the list with low/no OI? Steve

        • Barry B October 26, 2012 9:58 pm #

          Steve,

          Interesting twist on Linda’s question!

          Actually, these are two different issues. Linda’s question had to do the volume of the underlying (stock). Your question has to do with the option volume and option liquidity. We do not screen for Open Interest (OI). This is because it has to do with the subscriber’s selection of the option (DITM, ITM, ATM, OTM, DOTM)…which has to do with the subscriber’s opinion of the market, as well as their risk tolerance.

          Alan has provided considerations relative to Open Interest. See Alan’s blog article on Open Interest…the link is below:

          http://www.thebluecollarinvestor.com/open-interest-and-volume-plus-non-standard-options-2/

          Best,

          Barry

  8. Barry B October 26, 2012 4:43 pm #

    Premium Members,

    Due to the potential impact of hurricane Sandy, the Premium Report may be late this week. Since both Alan and I live in the direct path of the storm, there is an outside chance that we may have power outages. As a precaution, we wanted to make sure that we gave you a heads up.

    Barry and The BCI Team

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