Papale on the Volatility Skew

Today is NFL draft day.  And if you are a rabid football fan, you are probably glued to all the sports talking heads and the over the top analysis of how selections might play out.  While I am only a casual football fan, I can’t help get a bit caught up in all this draft hype.  So for those who will be watching tonight  – have fun and good luck.  You’re on the clock.

Markets move up and markets move down.  And with those price moves, implied volatility can move as well.  But in addition to changes in IV, the skews have a tendency to change as well.  The skew is the relative price relationship between options at different strikes or months.  When we say for example that implied volatility is going down, we mean the general price level of all options are falling; i.e. the extrinsic portion of the option is declining.  However, it does not address what may be happening to the relationship between options across different strikes and months.

Implied Volatility is an average but each strike may move a bit differently.  That non uniform movement across all options creates what we call the skew.  The skew, along with implied volatility, will have an effect on the performance and profit and loss of your position at any given time.  In the equity world, in a given month, calls trade at a lower IV than puts – reflecting the embedded downside fear and demand for puts for portfolio protection.  We talk about the two things  that drive option prices and ultimately profitability – movement in underlying and implied volatility.  But when looking at IV look also at the skew.  It will provide valuable insight into your trade performance.

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