Choosing Moneyness for Measuring the Options Volatility Skew
Summary
The document considers whether liquid in-the-money options should be included when describing an implied volatility skew. One response says inclusion is not inherently wrong, but at-the-money and out-of-the-money options may be more informative because skew is often clearest in out-of-the-money contracts, where sentiment and perceived risk can have stronger influence.
A second response recommends excluding especially deep in-the-money options to make the skew more stable through time. Its reasoning is that, with spot held constant, option price changes near maturity can translate into different implied volatility movements across moneyness: the effect may be larger for in-the-money contracts than for out-of-the-money ones. The discussion offers qualitative guidance rather than a tested comparison, and it does not prescribe a universal filtering rule. Practical choices depend on the analysis objective, data quality, maturity, and how the skew is defined; liquidity alone does not determine whether a contract is analytically useful.
Key ideas
- In-the-money options can be included, but may add less insight to a skew analysis than at-the-money and out-of-the-money options.
- Out-of-the-money options are often used because their implied volatility can reflect perceived risk and sentiment more clearly.
- Deep in-the-money options may produce less time-stable implied volatility patterns as maturity approaches.
- The advice is qualitative and does not establish a universal moneyness filter.
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Full text
# Describing the volatility skew with a set of options # Describing the volatility skew with a set of options Say you have a set of options data, and you filter the dataset based on certain criteria such as the bid-ask spread, open volume etc. and you end up with a set of liquid options based on said criteria. If your options dataset contains liquid ITM/ATM/OTM calls and puts, would it be wrong to describe the volatility skew using the ITM calls and puts as well? If that is the case, should I manually remove these ITM options? Because I usually see that only OTM and ATM options being used to describe the skew and for some reason my filtering algorithm did not remove the ITM options (or detect them as illiquid, which is the normal case). ## Answer by Sane (score 1, accepted) https://quant.stackexchange.com/a/79140 It is not necessarily wrong to include ITM options in your analysis of the volatility skew, but it may not provide as much insight as focusing on the ATM and OTM options. The volatility skew is often most pronounced in OTM options, as they are typically more influenced by market sentiment and perceived risk. ## Answer by KaiSqDist (score 0) https://quant.stackexchange.com/a/79246 Answering my question for anyone's interest in this topic. I took indirect inspiration from this post: How does an option's time value depend on moneyness? On whether to include (perhaps more so for deep) ITM options to describe your volatility skew - my suggestion is no. The reason for this is because, as an ITM (OTM) option matures, the option price increases (decreases) by a lot (little). Assuming the underlying spot is constant, this large increase in option price for an ITM option corresponds to a large spike in IV as compared to a smaller spike for OTM variants. Therefore, to ensure the time-stability of an option-implied volatility skew, it might be wiser to remove ITM options.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.