thanks a lot guys, you gave me a lot of things to think about. To be more precise regarding my situation: my underlying is an index ETF. My original idea was to use the surface to understand when the wings were overpriced vs the center and vice versa, and see if there was some sort of pattern across maturities..
Hey Chef, So far on ET the general consensus seems to be that for equities it is sticky strike. On Sinclair's book he says that actually it's a blend of both. Predominantly sticky strike when the market is range bound and transitioning more towards sticky delta when trending. Intuitively it makes sense: when range bound there is a lot of people looking at support and resistance, so there is a certain crowd acting on each key level. When the market starts trending previous levels are ditched and everybody is running after the atm level. Considering that markets are range bound most of the time, the general ET consensus makes sense.
James Yes, we calibrate the strike skew with a slope and derivative. We also have an approach for wings, < 15 delta but that is more nuanced. I put up a blog for this answer too: https://blog.orats.com/modeling-the-implied-volatility-surface-skewness-and-kurtosis This approach to the strike implied volatility surface for a month can be described as a 2-dimensional surface where the independent variables option delta and the dependent variable is implied volatility. It solves for the surface using the following summary characteristics strike slope and derivative. Strike Slope is a measure of the amount that implied volatility changes for every increase of 10 call delta points within the intra-month skew. It measures how lopsided the 'smile' or 'smirk' is. The derivative is a measure of the rate at which the strike slope changes for every increase of 10 call delta points within the intra-month skew. It measures the curvature of the intra-month skew or 'smile.' We chose just two parameters to describe the skew to get a reasonable fit for the fewest assumptions. Using this method of describing the skew has the additional benefit of producing accurate at-the-money volatility readings important for summarizing the term structure. Is this what you mean by calibrate the IV Surface / Option Chains? Matt
Baozi Thanks for the additional color. One way to see if wings are overpriced is to look historically. Using a slope and derivative can identify which wing, the OTM puts or calls might be overpriced. Then what we do is show the skew in terms of volatility buckets. Tracking areas of the volatility surface using delta buckets can help identify areas of over or undervalued parts of the skew. I put up another blog (you are making me work!) here to show our buckets at work, for example XLK: https://blog.orats.com/volatility-skew-and-buckets Matt
Sometimes it’s one. Sometimes it’s the other. Sometimes you move down the surface and vols don’t move. Sometimes you move down the surface and the atm vol stays the same (sticky delta).
I went back and reread Hull on this. He said there were two competing effects: 1. When equity price increases (decreases), IV moves along the skew curve, increases (decreases). 2. When equity price increases (decreases), IV tends to decrease (increase) and the whole skew curve may move down (up). But then he said 2 tended to dominate 1. Is that sticky delta or sticky strike or neither?