Papale on Skew

By Steve Papale

Writing this a couple days later than normal.  Was on vacation last week in northern Michigan.  Great week as always.  Made an interesting discovery – at least for me.  In our hotel room the thermostat went down to 45 degrees.  I never really paid attention to how low you can set these since we set the thermostat for the air conditioning in our house around 70 degrees.  So when my kids decided to set it at 45 degrees the air conditioning never shuts off.  Woke up at 4 am absolutely freezing.  They thought it was funny.  But I’ll get them back.

The relationship of implied volatilities across strikes is known as skew.  Skew can be either vertical (within a given month) or horizontal (across months).  As the underlying and uncertainty move,  skews too can ebb and flow.  However there is a basic premise that always exists.  Volatility always increases in the direction of fear.

For example, in stocks and equity indexes, the fear is to the downside.  This is because the world is basically long stocks via IRA’s, 401k’s, funds, etc.  In commodities it’s the opposite.  Fear is to the upside due mostly to supply shock issues like fire or drought.  So when the stock market goes up, everyone is happy.  But as things selloff, wealth erodes and fear sets in.  This is why IV goes up as stocks go down.  This is one reason why lower strikes trade at higher IV’s than higher strikes.

Prior to the crash of 1987, there was essentially a flat skew in stock options.  All strikes traded essentially at the same IV.  Since then put sellers want more premium to sell those out of the money puts because the fear is markets can do down faster and farther than we think.  So lower strike puts have a natural bid keeping them more expensive as measured by IV.  But higher strike calls have forces that keep them lower in terms of IV.  One as we discussed is that the world is long stock so people are happy when markets rally.  There is no fear demand for calls to protect to the upside.   Some of these long stock holders do what some of us do with our stock positions – sell calls against our long stock positions to bring in extra income and lower risk.  This embedded selling tend to lower the price of calls as measured by IV.  So opposite forces are affecting the shape of the vertical skew – fear on the downside and income enhancement on the upside.

Next week we’ll analyze the shape of the vertical skew and look at horizontal skews.

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