Assessing Option Skew Beyond Comparing Implied Volatility
Summary
The document considers how to compare an at-the-money call with an out-of-the-money call when each has a different implied volatility. Its central point is that implied volatility is inferred from market prices through a pricing model, often one that assumes lognormal returns. A lower implied volatility at one strike therefore does not by itself establish that the option is cheap; the market’s skew reflects expectations and preferences that the model does not capture directly.
The answers suggest comparing the current volatility difference across strikes with its historical range and assessing whether the expected realized volatility would change if the underlying rose toward the higher strike. They also note that skew varies with factors such as asset type, supply and demand, market conditions, and events. The discussion offers a framework for relative valuation rather than a definitive trade rule: historical comparisons and a view on future volatility can inform the choice, but neither guarantees that the skew is mispriced.
Key ideas
- Implied volatility is derived from an option price using a model, so it is not a direct measure of whether an option is cheap.
- A lower implied volatility at an out-of-the-money strike does not automatically make that option the better purchase.
- Compare the strike-to-strike volatility difference with its historical behavior.
- Consider how realized volatility might behave if the underlying moves toward the higher strike.
- Skew can reflect asset-specific patterns, supply and demand, market conditions, and event risk.
Tags
Full text
# How do you factor in skew when assessing implied volatility for a non-atm option? # How do you factor in skew when assessing implied volatility for a non-atm option? If you think volatility is too cheap, how do you decide if an ATM call or an upside call (which trades at lower vol because of skew) is better? Let's say you have a $100 stock. You think the stock will move on a 20 volatility. You have 2 choices: Buy the 100 strike call for an 18 implied volatility. Buy the 120 strike call for an implied volatility of 16. How does one intuitively go about assessing what the better option is? Purely saying, hey 16 is a lower implied volatility so it's better seems way too simple. Any thoughts/ideas? What other things should we know? ## Answer by Hui (score 2) https://quant.stackexchange.com/a/40255 First of all, you should understand where the IVs are coming from and the assumptions made in the model to derive the values. IVs are solved through option pricing models by the given market prices of the options. Many of the option pricing models assume underlying securities are lognormally distributed, for example BS model. However, the market participants disagree on that. Volatility smiles(smirks) actually represent how market participants disagree on the model, because if the market prices of options are exactly same as BS model, the IVs smiles are actually a flat line. So buying an option from a strike with lower IV doesn't mean you get a "better deal", because the distribution of underlying might be totally different from the model used to solve IV. Also, options prices(also IVs) are determined by many factors such as type of securities(FX are more like smile but equities indexes are more like smirk), supply-demand, market scenarios and idiosyncratic events. So staticly look at the IV skew doesn't tell you if it's truely, and relatively, cheap or expensive. However, looking at the dynamics of skew change might tell you the option is relatively cheap or expensive comparing other strikes. Lots of hedge funds' option groups are actually trading for skews. There are a few skew trading strategies you can easily find online ## Answer by dm63 (score 1) https://quant.stackexchange.com/a/40256 Here are two questions you should ask: (1) looking at historical information, how cheap has the 20pct otm call traded at versus the ATM ? Is the 2 point discount high or low versus history (2) what do you think will happen to realized vol if the stock goes to 120? The market, through the skew pricing, is saying it will go down significantly. If you do not believe that, collecting the 2 point discount may be a good idea.
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