I'm trying to wrap my head around what the IV smile means for a stock and I have some ideas, but wanted to make sure they aren't misguided. In my case, I am considering buying SPY LEAPS (e.g. 2 years), and noticed that the bottom of the IV curve is also approximately where I expect the shares to be. For near month and weekly options the low point is almost always ATM, and the sides of the curve are very steep. However, for longer options the low point is usually very deeply OTM, and the curve is much flatter. My interpretation of this is what I want feedback, so I am looking for input on the following statements: - For buy-and-hold strategies, it's generally better to buy at low IV, and sell at high IV. This means it's better to buy OTM now, and sell ~ATM later. The alternative strategy, buying ATM now, and selling ITM later, all else being equal, is worse because the strikes would be much farther up the curve. - The low point in the smile is where, on average, people think the price is going to be. The reason the low is ATM for near options, and OTM for SPY, is based on the expectations of where SPY will be in a few years. - If the previous idea is true, this also means it's reasonable to derive where the stock price should be in 2 years. This should hold for any security that is optionable. A side example is that for something like SQQQ, which suffers from volatility drag, will not achieve the -3x of the long term. However, using the volatility smile, we can see the bottom of the curve is around ~2x which would account for the drag. - The IV curve being steeper OTM/ITM for near options is due to the higher level of certainty about where the price will go. A trader with an advantage over the market can charge more or offer less, since they know more where the price will actually go. The LEAPS curve is much flatter because much less is known about the future. There is less of an advantage to be had. (I use this to hopefully justify that I am not getting ripped off ) I don't have a picture handy, but there are some 3D graphs of the IV with money-ness, expiration, and IV. It appears like a canyon. My mental model is if I put ball at the starting point, the ball would roll towards the lowest point, wobbling back and forth along the way. I'm curious how other people think about IV, and if my ideas above have any merit?
I gotta run to the gym before my slot is over (fucking hell), so I'll be brief about the topic that can take days to discuss. In short, the skew reflects the imperfect assumptions of the Black Scholes model. These are (a) normality of returns and (b) stationary volatility which clearly do not hold in the real world. So the options traders buy or sell options in a way that "corrects" the market in the right direction. A more nuanced academic approach would point out that the volatility and, subsequently, the skew is driven by correlation in indices and by credit in single names. Of course, "in nature" this is expressed via flows from various market players. I.e. there are people buying puts to hedge from the market declines or to hedge their specific positions and there are people overwriting calls to generate income. As a result, there are aways more buyers for puts and more sellers for calls which creates a lopsided volatility skew.
The distribution of returns is leptocurtic and asymmetrical. OTM put options are "mispriced", because we will never know when a swan will happen again. It is true that expected and priced volatility is usually higher than the volatility that eventually realizes, but it is very cheap compared to the swan event. So we need to know when volatility is high and when it is low. Moreover, IV sometimes exceeds the ordinary, and its price skyrockets, due to particular events. And so we need to know how to trade it. We have made two videos to address this: https://www.sunnymoney.cloud/free-c...s-prices-volatility/what-moves-price-options/ https://www.sunnymoney.cloud/free-c...enu/read-markets-mc4/mc4-volatility-analysis/ bye
Pre 10/87 almost no volatility skew. Post 10/87 skew becomes commonplace - ask yourself why and you'll get a sense of how the community hedges and why skew has become commonplace.
As a side comment, it's incredible that it was the case. The whole idea of "up the staircase, down the garbage shoot" is as old as the hills, it's not that Black Monday was the first ever big move (though it was the biggest ever in recent history).
Thanks again for the reply. Is there any place you'd recommend reading more about it? I think I have exhausted Investopedia. Not sure what you mean here. The volatility smile should be per security; not sure if you mean indices in general. Also not sure what you mean by single names. Of the distributions I know (Normal, LogNormal, Cauchy) none of them seem to really match the data I see. Any more guidance on what distributions people use to model the price? (such that the volatility curve would be flatter?) I feel like the take away from this is that BS is not a good measure of option pricing away from the money. However, why do we still use IV as a option metric?
A second order interesting observation is that index volatility skews are generally steeper than those for the single stocks in that index.
Actually, the further East you go, the flatter the index skews get. The must be something in the water there