I don't think that the B-S model is predicting anything - it's simply calculating the the volatility that's implied by the market price of an option - it's the market that makes the assessment of predicted risk. My original question is asking whether the skew is caused by a flaw in the B-S model; an inefficiency in the market; or some combination of both. If the B-S model is basically sound - meaning that most of the skew is exaggerated market fear of infrequent events because those events are so memorable (It's similar to how we fear airline crashes more than car crashes, even though airlines are safer than cars, because the idea of an airline crash is so much more horrific.) - then the skew can be exploited for profit similarly to the way those life insurance vending machines in airports exploit exaggerated fears - we only need to find out which iv represents the most reasonable assessment of volatility risk. My guess is that atm calls will come the closest to being a realistic assessment of volatility risk; that we have differing personal opinions doesn't matter if empirical testing can show that there's no advantage, before transaction costs, of either buying or selling them over time. Also: if there's no empirically calculated advantage to buying underpriced otm calls and selling overpriced otm puts, then they are not really mispriced; instead, that would prove that B-S is not accurate at converting option prices into iv's, either through the the whole option chain or maybe only for the otm options.
I look at this a little differently. The ATM IVol is the based on the current market expectation of uncertainly/price movement. If you have a statistical way of determining that: -the market is mis-pricing future price movement -the market will shortly do something to raise or lower Ivol based on some other item not currently being included you can make money buying/selling ATM vol and delta hedging. In general, the market has become very good at this and profiting from the market mis-pricing ATM options is a difficult way of making money consistently. Hard to find an edge this way, IMO. IMO, the OTM options are typically where you can find an edge. It is not a flaw in any model, just a flaw in one of the assumptions that market players put in the model. There are a lot of "traders" willing to take a shot on "cheap" (more low priced than cheap) OTM options, that in general, expire worthless. There are also many long side portfolios willing to pay for insurance on their portfolios. I'm not sure that this is working the way they want it to, but they buy OTM puts and are willing to pay up for them. There are also traders that like to sell options just OTM and because of margin rules, need a hedge. They are happy to sell an options at $1.00 and have to buy the OTM put at $0.10 to be able to hold the position with less capital than the naked position. This created an opportunity for the guy that just wants to sell the $0.10 option. Again, this is not a flaw in any model. The models are only as good as the inputs into the model. Since none of us know what is going to happen, you have to look for an edge that has the best expectancy of making money overtime. Delta hedging ATM options without some opinion that the market is wrong, is a tough way to make money.
Sorry, that was not meant toward you, but in general from the post over all. Yes, your last statement I agree with. What many on ET often say is that trading ATM options is better than trading OTM options. That buying vol is better than selling. That sell ATM options is better than OTM options. Maybe it's just too early and I need more coffee.
I have a question: is is better to buy underpriced otm calls or sell overpriced otm puts? On the one hand, I expect that the effect of put-call parity causes the put option chain to be more overpriced so that the otm puts are more overpriced than the otm calls are underpriced; but on the other hand, I would have to buy even further otm and more overpriced puts to offset the risk of selling otm puts, which cuts into the edge and also brings the added disadvantage decreased liquidity and other transaction costs. With otm calls, they may not be as mispriced, but there are none of those other disadvantages and costs. Also: while the otm calls will have infrequent wins, the losses will be relatively small; while the otm put spreads will have a high win rate, but the large losses can create a money management difficulty and sleepless nights.
This is all just my opinion. I prefer to sell OTM options in indexes rather than "stocks". When OTM options expand in individual underlying, you take the risk of "hot" money knowing something you don't. It increases the risk of an "event" causing a loss. With regard to Index options like SPX, selling OTM puts is "easier" than OTM calls, but not safer. The calls trading at the same cash value as the puts, are much closer to the the current price. So as the market moves up, you are more apt to have to hedge or get a margin call, from OTM calls. However, when the market does drop, even though the OTM puts you sold in SPX are still very far out, you have what I call the risk of a "liquidity event". Screen markets can get very wide, increasing mid-point values, increasing IVol, increasing the likely hood that you will have to pay up to meet a margin call. Many of the MM at the exchange are short these options too. During these event, prices expand faster than normal and feed on themselves toward the end of the day with margin calls. You just don't get that on the upside from selling calls on index options. They rise slower, and the markets Bid/Ask spread tends to stay narrow. So you need a balance. I would do both and monitor market conditions. This strategy seems to works best when the VIX is around 17 to 22. If it were easy everyone would do it. It take a lot of capital and discipline. My clients tend to sell both and watch market conditions for how much the sell and how often. You have to balance current prices, expectation of market moves and risk of being wrong. They also tend to stay short term to reduce Vega risk.
Now I'm confused; I was comparing "selling overpriced otm put spreads" with "buying underpriced simple otm calls". So even with their low iv you believe otm calls to be overpriced?
I have noticed that when on a Friday, the weekly SPX straddle is around $20, which I think is in the low historical range, volatilitiy increases the following week. Last example was July 31st, and I remember seeing that same straddle worth $28 on August 6th. Even ATM options can be “mispriced”.
These are not an either or to me. I would sell an otm put spread if I felt the stock won't go down. To make money buying the call spread, you need the stock to go up. You ofcourse can do both if your bullish. It changes the dynamic of each spread if you hedge the deltas with stock.