I'm new to options and trying to find my way around. At this point, I've read a lot of material, but can't really make heads of tails of it all. Think of each book/article as a piece to a puzzle. I have 100 pieces to a puzzle spread out on the table, but I can't see the big picture. Can someone explain to me why I don't see a front month volatility smile on the indices? Once I get this answered, I can move on to understanding the significance of skew/smile and how it applies to trading. Thanks.
If I compare the May options on Google to the May options on the Russell 2000 Index, it's far more apparent on GOOG than it is on RUT. So maybe a better question would be why is it more pronounced in individual equities than an index?
The Russkie is an index that represents some 2000 issues, whereas GOOG is just one issue. So, corporate events, upgrades/downgrades, and news releases will impact GOOG alot more than a broad index. Since event volatility is dampened in an index, you will see much larger vol skews in GOOG. Make sense?
The "smile" on indices is not much of a smile - more like a crooked smirk. Every strike price trades at a higher implied volatility than the strike above it, and a lower implied volatility than the strike below it. In other words, as you go from the OTM calls (highest strikes) to the OTM puts (lowest strikes), every strike trades at a higher volatility than the strike above it. So a graph of the implied volatility on a stock index looks not like a smile, but like a gently sloping line. Is that what you see?
Div - Yes, that makes sense. Thank you. dmo - For the puts, yes, I see a gently sloped line. OTM puts trade at higher IV's than ITM's. For calls, however, the line slopes up until one strike past ATM, then it goes flat. So, the far OTM strikes trade with the same IV as the strikes one away from ATM. Why is that? And can I conclude the far OTM's are overvalued?
Are you talking about S&P 500 options? That doesn't sound right. The out of the money calls normally trade at a lower IV than the at-the-moneys, progressively lower at every higher strike. If you tell me what exactly you're looking at, and the month, I'll take a look and see if I see the same thing you do.
More specifically, here is exactly what I see. Russell 2000 Index Options ($RUT) May 2008 Mid Implied Volatilities 700 C 23.8% 710 C 22.5% 720 C 21.3% 730 C 20.1% 740 C 19.7% 750 C 19.6% 760 C 20.0%
I have pretty much what you have Chili. So where's your confusion? Are you wondering why it doesn't look more like a smile? Personally, I prefer to call the chart of implied volatilities by strike the "implied volatility skew" rather than "smile," precisely because it doesn't always resemble a smile. Maybe that's what's throwing you off. Also, the options you're looking at are about to expire. So they don't have much "meat" on them. When options get very close to expiration they start acting a little dicey. For more typical examples I'd suggest looking at a later month - jun, jul, sep.