Implied volatility (IV) skew is one of the most important and interesting aspects of listed options. IV skew typically refers to the differences in the implied volatilities of options in the same expiration cycle with different strike prices. There have been many attempts in the academic literature to model the behavior of changes in skew, but the interpretation of skew information by traders is still done largely on a qualitative and ad hoc basis.
In “Quantifiable Implied Volatility Skew,” the featured article in the February issue of Expiring Monthly: The Option Traders Journal, Brandon Henry and I explain and evaluate two formulas for calculating implied volatility skew from option prices. We show how each formula correlates with market returns and changes in ATM implied volatility and we discuss several practical applications of skew data.
One of the many interesting conclusions we reached as part of this research was that average S&P 500 IV skew across the front few months has followed a discernible path over the last several years. We looked at 60- and 90-day weighted (“VIX-style”) averages of the data in addition to a simple arithmetic mean for one of the skew formulas. The chart below is taken from the article.
You can see a noticeable spike up in late 2008 and May 2010, both periods in which investors were inclined to be net buyers of puts and sellers of calls, the sort of classic situation in which any measure of IV skew would be expected to increase. What caught our attention, though, was that IV skew has remained high on this estimate throughout 2011 and early 2012. This has immediate implications for the timing and structure of options trades, and it will be interesting to watch how skew reacts as macroeconomic worries fade and U.S. economic data continues to improve.
We track IV skew according to one of the formulas discussed in this article in the Condor Options newsletter: weekly snapshots of the IV skew in SPY options serve as an important signal for evaluating trading conditions.
If you aren’t yet a subscriber to Expiring Monthly and you want to check out this article, you should hurry over. The February issue will be under our regular three month embargo after this week. The March issue promises to be just as interesting, as we are featuring an excellent article by Reed Hogan on the volatility risk premium in VIX options.