Thinking of volatility skew as approximated by the relative slope of the volatility surface for a given time to expiry, the skew can be a valuable indicator that shows option traders' biases towards a particular stock or index. Expensive options are a strong indicator of pending changes in a stock's price. The measure of expensiveness is the options implied volatility.
The ATM or vega-weighted implied volatility measure tells only whether the overall stock volatility is high, but doesn't yield any information about the markets sentiment of the stock's impending directional movement.
Under a Black-Scholes framework, options of the same maturity should in theory have the same implied volatility across strikes. However, in reality this is not the case. Supply-demand dynamics for individual option contracts can distort the price (and thus implied vol) at different points across the volatility surface's term structure and strike range.
The disparity of implied volatility between calls / puts indicates the position of traders in aggregate (volume alone does not imply net buying or selling). For instance, if OTM call ivol is higher than same strike/expiry put ivol, it may imply that traders favor an increase in the underlying.
To really understand the implications of volatility skew for impending price movements, one needs to analyze the volume of individual option contracts. Here is where volume can add color:
- High volume and low volatility may indicate that option contracts are being sold.
- High volume and high volatility may indicate that option contracts are being purchased.
Additionally, it is important to consider
- Time Skew: measures the spread between option ivol for contracts with same strike but different time to expiry.
- Strike skew: measure of spread in ivol for contracts with different strikes, but same time to expiry
- Higher ivols in NTM / ITM calls vs. puts may indicate a majority of call buyers, which can be viewed as bullish.
- An abundance of volume in the OTM call, coupled with low ivol, can indicate OTM call sellers. While this is a relatively neutral indicator of direction, it may suggest that traders aren't anticipating the stock rising beyond the OTM call's strike price.
While, except for a brief respite in mid-November, equity index options have not been this fairly valued in
nearly a year (measuring IVOL/30D HVOL), meaning that realized volatility has more closely matched the volatility implied by options prices (see chart at right).
From a distribution standpoint, the ratio is relatively middle of the road, at a 44th-percentile relative to the past year (see histogram at right).
I constructed an equal-weighted index that looks at 80%, 90%, 95%, 105%, 110% and 120% strike options' implied volatility relative to the ATM implied volatility. The index captures the degree of slope, or skew, in the ivol term structure on any given day.
In looking at the past year's distribution of this index, we see that today the degree of skew in the SPX is incredibly high, or a 5th-percentile event (see charts at right). This high-degree of skew has persisted well over the past month.
However, SPX skew is the highest among global indices, despite extensive focus on the deteriorating macros of Europe and concerns over China. Furthermore, an important implication is that SPX correlation has nearly doubled, which can be seen to indicate the degree to which the market has focused more exclusively on the
macro. This coupled with a flattening of the VIX term structure (at right) due to upward pressure on spot/near-term contracts may be indicative of market expectations for higher volatility due to an impending pull-back.
The sovereign macro risks seem to be inherently driving the market...
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