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Why Equity Implied Volatility Can Be Higher for ITM Calls

Article Quant Q&A · Author: Leo
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Summary

The document explains why implied volatility calculated from in-the-money (ITM) and out-of-the-money (OTM) equity calls may appear higher for ITM strikes. For calls, ITM contracts have strikes below spot, while OTM contracts have strikes above spot; the typical equity volatility skew can therefore produce the observed pattern rather than an inverted smile.

For constructing an implied volatility curve, the answer recommends using OTM puts below spot and OTM calls above spot, since ITM options are generally less liquid. It also cautions that far OTM quotes may warrant more reliance on bids than asks. The guidance is a general market convention, not a diagnosis of the researcher’s calculations: the document does not provide the option quotes, pricing assumptions, or data checks needed to verify a specific curve.

Key ideas

  • For calls, strikes below spot are ITM and strikes above spot are OTM.
  • Equity implied volatility is typically higher for lower strikes, which can make ITM calls show higher IV than OTM calls.
  • OTM puts and OTM calls are commonly used together to construct an IV curve because ITM options are often less liquid.
  • For far OTM options, the bid may be a more useful reference than the ask.

Tags

OptionsEquitiesVolatilityDerivatives pricing
Full text
# Inverted volatility smile OMXS30 Sweden?


# Inverted volatility smile OMXS30 Sweden?












I am researching volatility smile for school and have just calculated the implied volatility for OMXS30 call options with different strike prices. However, my OTM options have lower implied volatility then my ITM options. What have I done wrong or can this be right. Should the smile not be the other way?

I am a newbie so all help is truly appreciated.

## Answer by Frido (score 1)

https://quant.stackexchange.com/a/81100

As you specifically mentioned that you use call options, the shape of the smile you obtain is probably correct.

For call options ITM means $K < S$ and OTM is $K > S$. Typically equity IVs for $K < S$ are higher than for $K > S$.

However, as mentioned by @KaiSqDist in the comment, it is more usual to use OTM puts ($K < S$) and OTM calls ($K > S$) for IV construction as ITM options are typically less liquid.

Furthermore, for far OTM options you may want to trust the bids more than the asks.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.