I'm not sure I %100 understand you. Are you saying that because of the skew OTM iv increases faster (and increases it's rate of increase) than ATM iv when spot vol increases, and because of the iv increase premiums don't decrease? In my mind, if spot vol increases, there should be a better chance that OTM's will expire out of the money, and the premium should reflect that somehow (by going down I would imagine). I think you are saying that instead of premiums going down, iv increases, giving the same effect. Thanks, - The New Guy EDIT: I'm not sure if you picked up on this but I meant ITM when I wrote OTM.....
Only if the vols revert, but the opposite condition applies. Vols should rise in a broadening distribution of spot prices. What I am stating is simply that the vol smile gains curvature into a vol-increase. I am trying to isolate vol-cuvature from the "rising tide" of an increase in aggregate, strip vols.
I get everything about that except the first statement. I think I'm missing something obvious because you seem to imply that understanding that the curve/skew increases when spot vol increases (broadening distrobution) should explain to me why ITM call premiums don't increase at the same time. Possibly my lack of ability to correctly state whether I'm talking about ITMs or OTMs is causing my confusion.... - The New Guy
Yes, ITM and OTM call vols decrease into a decline, but only if viewed as a static-strike ladder. IOW, the initially OTM puts become ATM as the underlying trades to those strikes. OTM puts become ATM -- losing skew curvature, but gaining from the strip-vol increase. The practical use of this infomation is to time bull or bear straddle trades. Otherwise the exposures tend to offset.
OK, so back to my original question which I didn't word well and used the wrong terminology for. Is it safe to assume that ITM premiums decrease as spot vol increases (assuming they are deep enough ITM that they don't become ATM if the spot price rises as vol increases). And given the same logic, OTM options should be less OTM as spot vol increases, and therefore the premiums should increase, no? Thanks, - The New Guy
No, an increase in implied vol leads to an increase extrinsic values on all options, excluding skew or smile attributes. Market decline: OTM calls & puts lose vol from smile curvature, gain from strip vols. ATM vols on the static price ladder increase. Market rally: OTM calls & puts gain from smile curvature, lose from strip vols. ATM vols on the static price ladder decrease.
So then which assumption is wrong: 1. An increase in iv of ITM's means there's a greater chance of them expiring OTM. 2. An ITM call with a higher chance of expiring OTM is worth less than a similar ITM call with smaller chance of expiring OTM. Thanks, - The New Guy EDIT: or am I wrong in assuming that a gain in IV can come from an increase OR decrease of spot prices?
#2 is incorrect. The probabilities are symmetrical. The ITM call under an increasing vol has a greater potential to trade >ITM as well. Increasing the likelihood is analogous to a flattened/widened distro; IOW, where the many locales under the distro share a similar freq of occurrence. An increase in vol makes both scenarios more likely.
ahhhhhh..... i wish you could have seen the size of the lightbulb that just went off over my head. Thanks! - The New Guy
Cool, glad to hear. Another method is to think of the distro in visual-terms... both a flat/wide and narrow/peaky distro can share equal area under the curve. An increase in implied vol causes the area under the distro to increase, regardless of shape.