Call IV vs Put IV on index options

Discussion in 'Options' started by ChanTrader, May 15, 2008.

  1. When I compare an OTM bear call spread against an OTM bull put spread, the same distance (1 standard deviation) away from the current underlying index price, it seems like the calls are always cheaper (much less IV) than the puts.

    This has the effect of making it seem much better to be writing bull put spreads than bear call spreads, and even more so because of the upward bias of all the major indexes (SPX, NDX, RUT).

    Why does the market price the options this way? Shouldn't the upward bias make the bear call spread more expensive because it has the higher probability being ITM?
  2. The price of the credit spread depends on a number of factors. You are comparing put and call credit spreads where the short legs are equidistant from the current price of the underlying and you are assuming that they must therefore be priced similarly. This is not so. Your short call will have a different delta (and impl vol) from the short put, despite being the same distance from spot. The same goes for your long (hedge) legs. The result is that the spreads will be differently priced. You'll also notice that the impl vol are generally higher for the puts relative to the calls, mainly because 'things' generally drop faster than they go up :).
    And also, the bear call spread doesn't "have a higher probability of being ITM" as you assume. If it did then you would receive a higher premium for selling them. A rough rule of thumb is that the individual option's delta reflects the probability of it EXPIRING ITM, but some would argue whether this holds true.
    In summary, there is no 'edge' in writing put credit spreads over call credit spreads.
  3. dmo


    Options on indexes and most individual stocks are such that the lowest strike has the highest IV, and every higher strike trades at a progressively lower IV.

    There are many theories as to why that is, but they mostly boil down to the fact that more people are long stocks than short, and OTM puts serve as insurance - and therefore command a premium.

    So every time you buy a lower strike (put or call, doesn't matter) and sell a higher strike, you're overpaying for that spread (or getting underpaid) relative to its theoretical value.

    Every time you buy a higher strike and sell a lower strike, you are buying that spread at a discount to its theoretical value - or selling it at a premium.

    So your observations are correct, and certainly worth taking into account when deciding what kind of spread to buy or sell in order to play your opinion of where the underlying is headed.
  4. Thanks a lot for these explanations.

    I can now understand why IV is generally higher for lower strike prices ('things' going down faster than up / puts as insurance). However, why is there delta skew as well? I had (falsely) assumed that a put and call with strikes equidistant from the current price would have similar delta. Yet the delta is almost double on the put side.

    Is it for the same reasons as the IV skew?
  5. dmo


    With your options calculator, calculate the delta of an otm put with a low IV, then try calculating the delta with higher and higher IV's. You'll see that the delta increases.

    Since each otm put is trading at a significantly higher iv than the equidistant otm call, it naturally has a higher delta.
  6. Delta and IV do reflect the odds of the option expiring ITM. Not the statistical odds, but the betting odds. The price point at which bets for (long) and against (short) are in some sort of balance.

    As long as all the combinations that present a risk-free arbitrage are lined up, all the other prices can do whatever they want if there's enough money to push them in that direction.
  7. What you are observing is the Vol Skew. It's happened since 1987. The skew is simply a reflection of OTM calls being sold to pay for OTM puts. It basically displays the fear the market has of another crash.

    I take advantage of the put skew all the time. It's one of the reasons I like put calendar spreads so much. You do have extra value when you trade with it. Good topic..
  8. [I take advantage of the put skew all the time. It's one of the reasons I like put calendar spreads so much. You do have extra value when you trade with it. Good topic.. [/B][/QUOTE]
    That's the advantage of an OTM put calendar. When underlying drops, both delta and vega (iv rush) are working in your favour. With an OTM call calendar as underlying goes up only delta works in your favour and usually iv stays flat or declines (which is not good for a long vega position).
  9. And when your wrong (the underlying goes higher) the skew, helps the puts hold their value better.