By Steve Papale
My new favorite video is of a guy named Lew Dunlap. Lew was at the Colorado Rockies fantasy baseball camp recently when it was his turn to bat. A pitch was delivered that seemed a little a little too close to the old chin so Lew, needing to protect his property and the plate took offense and began to charge the mound. The umpire stepped in and escorted him to his base. No altercation. No bench clearing. The game went on. Oh yeah, did I mention Lew is 88 years old.
The relationship of volatilities along strikes within a given month is known as vertical skew. In the world of equities, the farther down in strike price we move, the higher the implied volatility.
For example an IBM 165 put has an IV of around 18. Moving down to the 140 strike, the IV jumps to 26. The price of the 140 put is less but the IV is more. So in terms of expensiveness of the option, the 140 put is more expensive than the 155.
Remember, IV is based on extrinsic value, not on absolute price. This upward moving skew as we move down in strikes has been around since the crash of 1987. Prior to that the skew was pretty flat. No one believed such a large move could occur. Since that time the market has been willing to pay a premium for extreme downside protection. The market is willing to pay this higher price even though statistically it is a worse proposition than the cheaper 155’s. That because at least partly, people look at absolute cost as a decision factor with greater consideration than economic rationale. And because of this embedded bid for all out of the money puts, the skew on those strikes is what we would characterize a flattish. That means the IV’s eventually level off and deltas tend to stay flatter as we move between strikes. These skews are fairly consistent across equities and equity indexes. In our trading we can recognize and incorporate these relationships in how we structure and manage our trades. We start to peel that onion back next week.