Tuesday, February 11, 2014

What is options skew?

Options at lower strike prices (OTM puts) have higher volatility than higher price options (ATM puts) and the OTM calls.

IV OTM puts > IV OTM puts

This higher volatility exists for two reasons:
  • The vast majority (pension funds, mutual funds, 401(K)s, and the retail public), of the equity positions are long. Long investors, purchase puts as insurance against a portfolio drop, which increases the demand for puts. Increases in demand create increases in price. The way to make an option more expensive is to raise the volatility.
  • Since the market moves down faster than it moves up bear markets are much more abrupt and realize outlying returns faster than bull markets. The more expensive OTM puts compared to OTM calls is simply a reflection by the options market that downside risk is greater than upside risk.