Understanding Option Skew -- What it is and Why it Exists

I've had requests for a few articles on basic and advanced option theory. Let's start with my favorite part of option pricing, the volatility skew.

What Does Skew Mean?
Volatility is often discussed as a single number. In the real world, the volatility of each strike price and in each month is different than the neighboring one. Skew is simply the volatility curve formed by plotting the individual volatilities of each strike. The shape of this curve is often referred to as the volatility “smile” or “smirk.”

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Normal Skew Shape
Normally the skew forms a downward smile (or smirk) -- lower strikes have higher volatility than higher strikes. I’ve included a skew chart for IBM Jan 2012 options on 2-14-2011 below.



We can see the lower strike prices (OTM puts) have higher volatility than the ATM options and the OTM calls. This volatility smile shape exists for two reasons:

First, because of a basic real-life principle about the investing world: The vast majority of the equity positions are long. This is driven by rules that govern pension funds, mutual funds, 401(K)s, and the retail public, as well as a general phenomenon that investors prefer to own securities in the expectation that they will rise in price rather than sell them in the expectation that they will decline. These realities have a direct impact on options prices (and therefore volatilities).

A long investor makes two general options trades to hedge his or her long stock. The first is to purchase downside puts as insurance against a portfolio drop. This increases the demand for downside puts. Like all free-market prices, increases in demand create increases in price. Ceteris paribus, the only way to make an option more expensive is to raise the volatility.

The second hedging trade is to sell calls against long stock (covered calls). This acts both as an income-generating strategy and as a hedge for downside moves. Call sellers imply a decrease in demand for upside calls. This decreased demand lowers prices (volatility).

The second reason a volatility skew exists is that the market moves down faster than it moves up. Historically, bear markets are much more abrupt and realize outlying returns faster than bull markets. The more expensive OTM puts compared to OTM calls is simply a reflection by the options market that downside risk is greater than upside risk.

On a side note: Remember that the stock market doesn't create new rules, it simply reflects the rules of the universe. Our universe imposes on us the reality that creation takes longer than destruction -- so bear markets (destruction of wealth) are faster and more abrupt than bull markets (creation of wealth) and option skew reflects that reality... I got too esoteric right there, didn't I?...

Stock Price and Volatility Movement
Normally, when stocks go down, vol goes up because investors that are long stock buy puts for protection which creates greater demand for options.

Alternatively, when stocks move up, vol goes down because investors that are long stock sell OTM calls for income which creates less demand for options.

Abnormal Skew
For certain types of companies, the demand for upside calls is so great that the skew (vol) bends up for OTM calls as well -- this can either be speculative call buying (like a takeover rumor or earnings speculation) or a company where the upside risk is perceived to be as great as the downside (like Solar companies and Bio-techs).

Yahoo! is a company that has been a speculative favorite of late for a possible buyout. I’ve included the YHOO skew chart for the April 2011 options below.



Note how the skew for YHOO is parabolic. The downside bends up due to the phenomena presented prior. The upside skew bends up due to the order flow, which is pre-dominantly speculative call buying on takeover rumors.

For the naturally curious reader, solar companies and bio-techs can be great examples of the second type of company -- those that exhibit an upside skew shape (the market reflects as much upside risk as downside).

Now that we have an understanding of skew, we can move to the next article which describes how to use skew to trade options.

Next article: Trading Option Skew