Why might a deep in the money call have a very low implied volatility? Don't deep in the money options tend to have a higher implied volatility due to the fear of extreme events?
Why might an ITM put have a high implied volatility? Does this indicate people are bearish on the underlying?
I am not particularly qualified to answer, but my guess is that, because the call option has not been exercised, there is the perceived possibility of substantial continued appreciation.
Your name is VolatilitySmile. And you still have no idea?
lol
A lot late to this post but this is funny and also ironic. I'm sure after all these years, he got his answer lol.
is it because people don't really want options that act like the underlying? or because they are cheaper to hedge against?
I'm guessing you're talking about equities, but in general it depends on what models you use to build the surface. Some probably overprice the wings, and others dampen them too much.
Furthermore, these contracts rarely trade so it's unlikely you are seeing even mid as the real implied price.
Because when it's trading that deep ITM, it's pretty much trading 1 delta (i.e. trading just like the underlying stock). There is very little risk of them losing enough value to take them out of the money.
Its not deep in the money options that generally trade at higher implied vols, but rather downside strikes. Deep ITM call = Far OTM put. Just to clear up any potential confusion.
One potential reason for upside strikes to trade at a premium to downside strikes is in the context of takeover rumors.
What about in the context of options on govt bond futures? I am thinking the disparate IVs I am seeing may also be due to the fact these options are seldom traded. Bloomberg shows implied volatility for contracts that have zero open interest for some reason.
lower strike skew is higher than higher strike skew because at lower strikes, there is a higher leverage(lower equity same debt). keep in mind implied vol is calculated for OTM calls and OTM puts(so strikes above the current price use calls and below use puts). people tend to overwrite deep OTM calls and overbuy deep OTM puts, contributing to the shape of the vol skew
The higher leverage explanation for skew is highly academic and is not really considered by traders to really be a factor. More of a function of market pressure (as you said tendencies to sell and buy certain wings) and negative spot-vol correlation.
I think derivstrading is God. The more I read his posts, the more I am convinced of this.
Regarding options on bond futures, I am not entirely certain but I think it has to do with inflation expectations. Higher inflation expectations will lead to higher IV for higher strike calls (and subsequently puts). You sometimes see the opposite of the equity vol skew in certain commodities where there is high inflation expectations, so it would seem logical that it would apply to gov't bonds.
There are also many types of skews that exist. The equity smile (I call it the smirk) is most popular. For currencies, you will notice that it is a full smile, with both lower and higher strikes having a higher IV than ATM options And as derivstrading said, individual equities can exhibit some interesting skews. If for example you have a biotech that is having a drug being reviewed by the FDA and that report is going to be released tomorrow and lets say the stock is 50 and if the report is positive it jumps to 70, and goes to 30 if its negative, then you will probably notice that the skew becomes a frown, with high IV for ATM options, and low IV for higher and lower strikes.
For a stock, I am pretty sure that ATM vol will never be higher than the far OTM options (except in instances like cash takeovers, where strikes beyond the takeover price will collapse in vol). The vol curve may indeed be flatter, but if you're expecting a big move on a news release this will affect all options (not just ATM). If the stock could go to 70, then it could go even further. Therefore, the 80, 90, 100, etc. options should have higher vol as well. As vol approaches infinity, all options become 100 delta.
If you expect the stock either drop by a huge amount or jump higher by a huge amount, ATM vol may rise because the best way to play a realized vol move like that without conviction is with ATM options (either delta hedged or straddles).
If you buy OTM calls for example and delta hedge, then if the stock jumps wildly lower you won't profit much cuz your gamma is small and will become even smaller as the stock drops. Therefore if there isnt really conviction on direction, you may see ATM vols get pushed higher.
of course it heavily depends on the situation (above is just a theoretical possibility), and frowns are rare in single stocks.
It very well could go to 80 and beyond, and it could have the drug fail and eventually file for bankruptcy within a year. How the stock performs AFTER the event is anyone's guess. However, before the event, if we assume that it is either going to 30 or 70, with equal probabilities of each (not 50%), the ATM strikes will have a higher IV than OTM and ITM strikes because ATM will be the most in demand options, since the stock doing nothing is the tail risk. It is similar to the fact that stocks going down by a lot is a tail risk for equities as a whole and as a result OTM puts have higher IV.
For a situation like this, the market is not really going to be forward looking. Once the announcement is made, than you will quickly see a reversion to a more normal skew (not necessarily the general equity skew). If the deal falls through (stock trading at $30), but the company has no debt, no lawsuits pending, and has cash on its balance sheet of $29.50 per share, you probably won't see the skew of OTM puts having a higher IV, because the implied distribution of going down by a lot is going to be thinner than the log normal distribution. This is true for any stock in general, but it is worth pointing out, I guess.
Obviously this scenario requires a lot of assumptions and they may or may not be realistic. But as derivs said, this is extremely rare. The point here is just to realize that a frown could potentially exist.
"If for example you have a biotech that is having a drug being reviewed by the FDA and that report is going to be released tomorrow and lets say the stock is 50 and if the report is positive it jumps to 70, and goes to 30 if its negative, then you will probably notice that the skew becomes a frown, with high IV for ATM options, and low IV for higher and lower strikes."
why is that?
Because at that point, the stock doing nothing tomorrow becomes the tail risk. The stock's pricing for tomorrow almost becomes like a binomial tree, with 70 being the upper node and 30 being the lower node. In biotechs, you will generally find that rationale and reason are usually suspended for the time being, so you cannot make a generalization about the market's position. Regarding equities as a whole, you can generally assume that the economy is Long stocks and because of this, there is higher IV in OTM puts, because when stocks go down, people get scared and scared quickly. So the tail risk in equities as a whole is the market going down. With biotechs however, the market may not have as clearly a defined position. Let's say 50% of participants think the report is positive, the other 50 think it's going to be negative. The only circumstance that BOTH parties would get hurt is if the stock does nothing. The scenario above is obviously an oversimplification, but I personally understand the skew to show where there is going to be the most anxiety. So if inflation expectations are through the roof, oil increasing in value is probably going to hurt the global economy as a whole and that would give rise to the opposite of equity skew.
hmm quality thread. never seen a vol frown before.
to OP a simple explanation would be if you're calculating IV off of stale prices (eg last trade) since deep itm trade infrequently.
here's a question for you options pros ... when would you ever early exercise an option? (i'm guessing related to some funky corp actions ...?)
Doloremque impedit dolores facere quo molestiae non. Aliquid nisi id dolore autem. Expedita deleniti quia ut ut. Quaerat omnis recusandae minima. Ullam et rerum repudiandae est. Quibusdam dolores ut voluptate amet doloremque sint.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...