"Skewed" Pricing in Options | Skinny on Options Data Science
Apr 22, 2016
Skew is an options trading term that describes the fact that the implied volatility of options on the same stock and in the same expiration are different from strike to strike. Typically, the further OTM strikes will have higher implied volatilities than less OTM strikes, and OTM puts will have higher implied volatilities than OTM calls. In that regard, skew accounts for the fear that markets crash down more frequently than they do up. That fear is represented in the "skewed" pricing of options - meaning puts are more firmly bid than calls because of the extra risk premium inherent in these contracts.
"The Skinny Around Skew," an episode from The Skinny on Options Data Science series, recently took on a wide-ranging discussion on skew.
On the show, hosts Tom Sosnoff and Tony Battista were joined by Dr. Data (Dr. Michael Rechenthin) and together they presented a clear illustration of skew and how it functions in the options marketplace.
Dr. Data first presents a chart of the monthly returns in the S&P 500 going all the way back to 1990 that shows the frequency of instances in which the market has moved by a given percent.
The data demonstrates that there are more instances in which the S&P 500 has moved down 10% or more as compared to up. This helps explain why a natural bid exists on the put side that pushes premium higher.
Dr. Data shows the range of prices for calls and puts across the option chain in the S&P 500. As you can see below, the puts are priced well above the calls even when the distance from the closing price is equal:
The above is a clear representation of skew observed "live" in the marketplace. Of course, the higher premiums will translate to higher implied volatility. This is the reason we often observe lower implied volatility on OTM upside calls as compared to OTM downside puts.
Dr. Data presents two different samples of options prices in the S&P 500 to reinforce his point. The first is taken from prices observed after a sell-off in the S&P 500, while the second reflects skew pricing from a “normal” day. As you might expect, skew becomes even more pronounced when the market is moving down.
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Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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