Using Skew Charts

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Using Volatilty Skews

As mentioned in the introduction, in real market environments the real implied volatility or “market volatility” of an option is not the same as the theoretical volatility level as calculated by a model.

The differences in values for different options can be viewed in the Implied Volatility (IV) column of the option series charts in an Analysis page.

When you change the system's Pricing Model using the Option Model dialog (accessible from in the Skew Chart's' function bar), the values in the Implied Volatility (IV) column will change.

When the Implied Skew volatility type is selected, the values of actual premiums are used. Normally this results in greater levels of volatility on either side of the ATM level.

Skew Plots

It is this phenomena that is graphed in the Skew Chart:

ogvolskewgraph1.gif

Option Display

A color is assigned to each expiry date, and each option is represented by an icon at its strike price (graphed along the bottom axis) and its skew volatility level, (graphed along the vertical axis).

Put icons are small squares.

Call icons are small triangles.

Best Fit Line

The data is smoothed out and a line is plotted for each group of options. The color assigned for each expiry date is used in the line.

Best fit lines for Puts are plotted as dotted lines.

Best fit lines for Calls are plotted as solid lines.

Interpretation

Skew Charts are good indicators of whether an option is overvalued or undervalued.

Usually volatility increases on either side of the “at-the-money” strike price. This accounts for the typical “smile” pattern of the Skew Chart.

These changes in volatility reflect the fact that in the real market each option series trades at a different volatility.

Plotting these market values identifies where each option is priced relative to the market.  In fact, the skew chart results from supply and demand, whichever options are in demand will trade at a higher volatility (price).

Therefore, a curve that slopes upward indicates that traders are selling downside options and buying upside options. This indicates that the market is worried about a huge upside swing.

They can also identify mis-pricing based arbitrage opportunities, particularly when there are points that lie above or below the best fit line.

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