Implied volatility is a key concept for covered call writers and put-sellers. It is a forecast of the underlying stock’s volatility as implied by option prices in the marketplace. In 2012, I published an article relating to implied volatility where volatility skew was discussed.
Volatility skew as defined in my 2012 article
The volatility skew is the difference in implied volatility (IV) between options with the same underlying security. Skews are categorized in two ways: they can be either horizontal or vertical. Vertical skews show how volatility changes depending upon the strike price. Horizontal skews refer to skews across time (that is, options with different expiration dates).
Another definition of volatility skew
Another use of volatility skew is when comparing the implied volatility of out-of-the-money calls and puts on the same underlying. When making these comparisons, strikes are compared that reflect the same degree of moneyness. For example, if a stock is trading at $47.50, the $50.00 out-of-the-money call strike and the $45.00 out-of-the-money put strikes are compared. With no market bias, we would expect the implied volatility and therefore the extrinsic premium values would be the same. In other words, there would be no skew as shown the chart below:
The chart reflects calls and puts with the same values and showing no market bias. These charts existed prior to the market crash of 1987 but no longer as long stock investors look to hedge their portfolios.
How do investors hedge their portfolios
Two common ways this is accomplished is to buy puts to protect on the downside or sell calls where long calls are closed or sold to generate income. The put-buying raises put prices and call-selling lowers call prices. Market bias is currently generally to the downside.
Post-1987 volatility skew chart for puts and calls
As a result of crash concerns, puts have become more expensive than calls which is reflected in the higher implied volatility of puts.
What is a reverse skew?
When there is bullish speculation, a reverse skew can occur (but it is rare). In these scenarios, calls are purchased, and puts are sold. The chart looks like this:
These are more common in volatility products like VIX which normally are inversely related to the S&P 500 so when markets move down, VIX moves up causing a reverse volatility skew as calls are purchased and puts sold.
Downside volatility skew example
Both strikes are (about) 100 out-of-the-money but put price and volatility is much greater than that of the out-of-the-money call.
Upside volatility skew example
Both strikes are $3.50 out-of-the-money but call price and volatility is greater than that of the out-of-the-money put.
Volatility skew is one way to explain why put premiums are generally higher than call premiums for out-of-the-money strikes. This reflects the market bias to hedge long-stock positions after the lessons learned from the market crash of 1987.
May 13th – 15th
Las Vegas Money Show
Bally’s/ Paris Hotel
Speaking schedule to follow
Your generous testimonials (new feature)
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
I am a fully retired GI doc and we live in West Palm. You are doing a great service for the average investor and I appreciate this. I am very concerned about the market given all the political, debt and recession issues and I think that using options will help me. Every time I use a money manager, I see they cannot beat the S&P.
I very much admire your skill set and organization!!!
This week’s economic news of importance:
- Factory orders Nov. -0.6% ((-0.2% expected)
- Markit services PMI Jan. 54.2 (54.2 last)
- ISM non-manufacturing index Jan. 56.7% (57.4% expected)
- Trade balance Nov. -$49.3 billion (-$53.7 billion expected)
- Weekly jobless claims 2/2 234,000 (225,000 expected)
- Consumer credit Dec. $17 billion ($22 billion last)
THE WEEK AHEAD
Mon Feb. 11th
- None scheduled
Tue Feb. 12th
- NFIB small business index Jan.
- Job openings Dec.
Wed Feb 13th
- Consumer price index Jan.
Thu Feb 14th
- Weekly jobless claims 2/9
- Produces price index Jan.
- Business inventories Nov.
Fri Feb. 15th
- Retail sales Jan.
- Import price index Jan.
- Industrial production Jan.
- Business inventories Dec.
For the week, the S&P 500 moved up 0.05% for a year-to-date return of 8.02%
IBD: Market in confirmed uptrend
GMI: 4/6- Bullish signal since market close of January 31, 2019
BCI: I am favoring out-of-the-money strikes 2-to-1 compared to in-the-money strikes.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to an improving market tone. In the past six months, the S&P 500 down 5% while the VIX (15.72) moved up by 45%.
Wishing you the best in investing,
Alan and the BCI team