Using Realized Volatility and History to Judge Option Skew
Summary
The document offers two practical ways to build intuition about whether an option’s volatility skew is unusually cheap or expensive. One approach is to consider how realized volatility might differ when the underlying is near a particular strike. If volatility tends to be higher around lower price levels, for example, that can help explain why lower-strike options carry higher implied volatility than at-the-money options.
A second approach is to preserve daily skew charts and compare their shapes across calm and stressed market episodes. This historical comparison can help a trader recognize typical patterns and changes in market conditions. The discussion is qualitative: it gives no formula, threshold, or evidence that either heuristic alone identifies mispricing. The realized volatility relationship is an intuition about option value, while historical charts provide context rather than a definitive valuation signal.
Key ideas
- Compare realized volatility at different underlying price levels to interpret implied skew.
- Higher expected volatility near a strike can help explain elevated implied volatility for options at that strike.
- Keep skew observations over time to compare calm and stressed market conditions.
- These heuristics provide intuition and context, but no standalone test of whether skew is mispriced.
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# What are some heurestics you could use to judge if skew is cheap or expensive? If any? # What are some heurestics you could use to judge if skew is cheap or expensive? If any? Are there rules of thumbs/models that you could use to develop intuition for when skew is cheap or expensive? From what I gather, volatility is a number that is backed out of price in a sense, "the wrong number to get the right answer". But then someone has to set the price, they have a sense of what the correct "skew" is, and I'm trying to understand some intuitive way of understanding. If for instance in a 100 stock ATM vol is trading at 35, and the stock has historically moved at 30 vol, you can have some sense that 35 is expensive. However, if the 80 strike was quoted at 35 volatility, is that cheap or expensive? How would one go about trying to answer this question? How did traders use to price skew before we had complicated models that went beyond B/S? ## Answer by dm63 (score 1, accepted) https://quant.stackexchange.com/a/53250 For example you could ask yourself what the realized volatility will be if the stock were to be at 80 at some time in the future. If the answer is ‘much higher than the realized volatility when the stock is at 100’, then that would be a reason why the implied vol of the 80 strike is higher than the at the money. The reason for this is that options derive much of their value from the expected volatility in the region of the strike price. Thinking about this strike versus realized volatility dependence is a key intuition for pricing skew in various markets. ## Answer by nbbo2 (score 1) https://quant.stackexchange.com/a/53263 Another example of a thing you can do. Every day I receive a chart showing the skew, i.e the IV versus strike for S&P options. Don't throw all those out the next day, save a few of them and tape them to your cubicle wall. That way you can develop a feel for what the skew has looked like in various historical circumstances, in quiet periods and in stressed periods (like on March 23, 2020), how it changes, what is normal, etc. Sometimes this goes by the fancy name of "stress testing" or "historical episode testing".
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