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From Theory To Practice

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Volatility Skew

From Theory To Practice

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

An important little wrinkle in the world of volatility is the skew that exists, which is largely credited to the downside velocity we all experienced during the 1987 crash. From our option pricing models, such as the Black-Scholes Model, we know that we can insert the price from a given strike and compute the implied volatility for that strike. This gives us a clean menu of implied volatilities across all of the strikes for an underlying.

What is interesting about these different implied volatilities is that they tend to exhibit a clear relationship: implied volatilities increase as you move OTM for puts, and implied volatilities decrease as you move OTM for calls. This phenomenon shows us exactly how and why “puts trade rich”, “calls trade cheap”, “put spreads trade cheap”, and “call spreads trade rich”. Several examples illustrating exactly how this works are discussed.

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