Just look what you've done to implied volatilities!

Volatility Skew Curve of SPX 500 Puts:

What are we looking at here and how have you options traders done this?

The chart shows a volatility skew for put options. This happens to show the skew for SPX puts for four option expiration cycles, with this skew chart snapped on October 9, less than a week before the October options stopped trading. What's being charted is the implied volatility of those options. Implied volatility, as you may remember, is one of the inputs into an option's price.

We think of implied volatility as a spot prediction of how volatile the underlying's price is going to be until expiration. If that were the whole story, though, then all the options in a certain option-expiration period on the same underlying would have the same implied volatility. When we looked at the chart of the volatilities, we wouldn't be seeing this shape: we'd be seeing horizontal straight lines.

Obviously, that's not what we're seeing. The horizontal axis of the chart shows the strike prices. As our gaze moves to the left of that chart, we see that the implied volatilities really kick higher at the lower strike prices for the puts, particularly for the about-to-expire October puts.

And that's where you, dear equity and option traders, are involved. You and institutions. What's happening? Retail traders hunt for cheap options, so if they believe that markets are ready for a rollover and they want to capitalize on that, they often buy the lower-strike puts, although we caution on this site against employing too-cheap calls and puts for directional trades. Equity longs and institutions want to protect their long positions and they buy puts below their positions to provide that protection. Some retail and professional traders might pick up cheap puts or calls to hedge their risk in case prices move against their positions.

We all know about the laws of supply and demand. When more traders or investors want to buy those lower-strike put options, their prices go up. All the other inputs are staying the same. What's being inflated is the implied volatility.

Notice that the volatility curve is much flatter for options with a longer expiration period, with the following chart comparing puts expiring in eight days from the time the chart was snapped with those expiring in SEP 2010.

Volatility Skew for Two Expiration Periods:

What about the skew for the SPX calls? Does it look the same as the one for the puts?

Volatility Skew for SPX Calls for Several Option-Expiration Periods:

What's happening here? In the October options, we still see the effect of speculative options trading, with traders seeking cheap out-of-the-money calls and slightly kicking up the curve in the OTM options on the right side of the chart. However, in the front-month options, the then-about-to-expire October calls, the implied volatility was much higher in the ITM options, and those aren't cheap. That wasn't true of the back-month options. In those, the volatility curve was relatively flat although sloping gently upward to the right.

So what's happening to the left of chart? In a section titled "Why Skews Exist" in James B. Bittman's Trading Options as a Professional, Bittman asserts, "There is no theoretical reason for the existence of volatility skews," but he also points to supply and demand issues as driving a particular curve's shape. A Wikipedia article notes, "In equity markets, a small tilted smile is often observed near the money as a kink in the general downward sloping implicit volatility graph. Sometimes the term 'smirk' is used to describe a skewed smile" (Volatility Smile).

In this instance, we're looking at a volatility skew for a cash-settled option. It's not possible to "buy" the SPX. For that reason, I would consider the possibility that, in the recent bullish atmosphere, some bullish options traders might have been buying deep-in-the-money calls as proxies for the underlying index. Some might be selling at-the-money calls against those long positions either as part of a bullish call debit spread or, if naked, as a bearish bet after such a steep rise. Either would have driven volatilities down ATM. Some event-related and option-expiration related effects might be impacting that shape, too.

Would we see the same thing if we were looking at a volatility skew chart for an equity or would we see the typical downward-slanting shape?

Volatility Skew for AAPL Calls for Several Option-Expiration Periods:

Here we see a relatively flat curve but with an obvious kick up in higher strikes on the October expiration. The October higher-strike calls were probably being picked up as cheap speculative trades by retail traders ahead of earnings, which were reported six days after this chart was snapped. There is probably something else going on, too, that contributes to that slight skew shape.

Retail investors and institutions who are long the stock may be selling calls to gain extra income and provide slight downside protection, but they're probably doing so at or near the current stock price. APPL spent much of the last two or three weeks prior to October 9 ranging from about 180 to 189, and we can see that the volatility levels were lowest in that range for October's expiration. Selling a lot of options has the opposite effect of buying them, of course: the option's price decreases. Implied volatility levels therefore are lower. The two processes--buying cheap speculative calls ahead of earnings and selling ATM calls to established covered calls against long positions--may well have created that shape.

If investors and institutions are really concerned about protecting their investments, they will be using the premium they collected by selling those calls to put a floor under potential losses by buying out-of-the-money puts. We'd then expect to see a sharp kick up in implied volatility in those OTM puts.

Volatility Skew for APPL Puts for Several Option-Expiration Cycles:

And, coming full circle from where this article began, that's exactly what we do see: a kick up in implied volatility for OTM puts. The skew is strong enough that we can suspect not only speculation by retail traders buying cheap puts but also institutional involvement as institutions seek to put a floor under their positions by collaring them, selling calls and using the premium to buy puts.

How can we use this information? One way is to do what I've just done: observe what's going on in the markets. How concerned are institutions about getting downside protection? Another is to employ volatility trades, those that buy the lower volatility (thereby, cheaper) options and sell the higher (and thereby, expensive) options. An old Trader's Corner article suggested that that typical smile seen in some volatility curves suggested that buying debit spreads automatically gives one an advantage. If that smile exists, the trader is buying the closer-in option with the lower volatility and selling the further-out option with the higher volatility, where the curve moves higher.

For example, one source calculates that a one-contract AAPL NOV 190/195 bull call spread would have cost $188.00 with the NOV 190's IV at 26.40 percent and the 195's at 26.75 as of October 9. If both options shared the same 26.40 implied volatility, however, the one-contract position would have theoretically cost $194, so the volatility skew did provide an automatic advantage, making the debit spread a little cheaper.

Some traders trade volatility rather than price, buying or selling spreads based on what they discover when scanning volatility levels or charts. However, I haven't personally used the volatility skew in this manner and believe it requires some expertise and honed instincts about how volatility typically works in a particular vehicle. If you're interested in that kind of trading, it's time to start paying attention and trying some paper trades before you ever attempt to trade volatilities.

I do of course compare volatilities between expiration months when I'm buying a calendar, and I want to be sure that the front-month option I'm selling has an implied volatility higher than or at least equal to the implied volatility in the back-month option I'm buying.

Traders should be aware that the options on commodity-based entities, currency-based ones and other types of underlyings sometimes have a different skew. We've all heard speculation about which airlines hedge against a rise in crude prices, for example. How would they do so? They might buy calls, just as equity traders hedging against a fall in equity prices might hedge by buying puts. That hedging against a rise in prices on commodities might kick up the implied volatilities in out-of-the-money calls more than is typically seen in equity-based options.

This article has been a brief overview. I don't know everything there is to know about volatility skews, as is proven by the way I cast around for a possible explanation for the skew we saw in the OCT calls. I'm sure some of you, particularly those of you who are either mathematicians who have studied models for option prices or former market makers who know the behind-the-scenes reasons for these effects, might know more than I do about these skews. If this brief overview article has piqued your interest and you'd like to know more about volatility and how it changes with the movement of the underlying, the change in sentiment and the passage of time, you might find Jim Bittman's book, Trading Options as a Professional to be helpful. Bittman discusses how volatility might be used when planning trades and choosing strike prices.