moneyness and implied volatility

Discussion in 'Trading' started by yz2006, May 14, 2009.

  1. yz2006


    being everything else equal, an OTM put/call is always carried with lower IV than a more deeply OTM put/call, is that correct?

    someone can enlighten me on the above question?
  2. In general, this is true for a large number of assets due to the presence of a volatility smile... You can read about the smile in a whole variety of places.

    I might add that, strictly speaking, your statement doesn't necessarily hold in situations where the OTM strike is close to a bound, such as 0.
  3. 1) You have to make a distinction in the type of item you are trading.
    2) Financial commodities; i.e. stocks, bonds and currencies, "panic" to the downside. That's why the (OTM) out-of-the-money put-options have higher implied volatility to the downside.
    3) Physical commodities; i.e. energies, metals and grains, "panic" to the upside. That's why the (OTM) out-of-the-money call-options have higher implied volatility to the upside.
  4. This is a valid explanation of the skew, i.e. the asymmetric nature of the smile, rather than the smile itself...

    In general, the presence of a smile is sometimes explained by people having an inordinate love for lottery tickets.
  5. sjfan


    Or, just risk adverse; or, anticipates a return distribution with fatter tails. In any case, the presence of a smile doesn't imply irrationality. It's a model artifact. But your general explain was very good.

  6. piezoe


    As a certified heretic i will be pleased to give you my take. Implied volatility is the euphemism used to refer to that part of an option's price that is determined by supply and demand. In other words, is that part of an option price that is determined by the market, as opposed to the other components which are fixed according to time, interest rates, etc.

    When an option is either in demand or its liquidity is low its implied volatility will be higher and you will have to pay a correspondingly higher price to own it, and you might get a correspondingly higher price when you sell it, unless you are trying sell an illiquid option which "smiles" at you. The "smile" has to do with decreasing liquidity of options (That is to say, the ease with which you as a buyer can be ripped off by the "smiling" option peddler as the option's strike price moves further and further out of the money.) :D