An indicator based on options increased IV as you go OTM

Discussion in 'Options' started by latinotrader, Nov 5, 2010.

  1. Usually, the more you go OTM the higher Implied Volatility (IV) options have.
    However this IV increase is not based on the bell curve and thus not constant.
    It is entirely based on market expectations.

    How about an indicator based on this?
  2. dmo


    Very sound approach. Use it as a contrarian rather than direct indicator - relatively higher OTM put prices are bullish, not bearish. This skew is quite stable - much more so than the skew in commodity options - so you'll be dealing with relatively subtle differences. But it's an absolutely valid approach. Just don't expect signals every day, every week, or even every month. This approach gives the most valid signals at extremes.
  3. High IV in OTM puts implies significant risks - Some traders have used IV in OTM Options as an indicator of potential default ... I read an article in Wilmott about it. The indicator was used to trade CDS in a more accurate manner. Tyco was one of the example stocks... The equity option gave Tyco's little secret away long before the CDS did.
  4. dmo


    That's a little different - in this case skew and IV is a reflection of insider info. Or at least, very educated guesses. In which case you would use it as a direct - rather than contrarian - indicator. Still a very valid approach when used with individual stocks. But for the market as a whole or for commodities I would use it to measure herd sentiment, making it a contrarian indicator.
  5. MTE


    I guess you are talking about the skew. I follow the skew on a regular basis and, as dmo pointed out, it does give good signals on certain occasions.