For as much as it’s talked about, especially in the current market environment, volatility is misunderstood by many people. That’s not surprising, it’s a very difficult concept, and something traders spend their whole lives struggling with. It’s the only variable input in the options pricing model, yet people still come up with different valuations as it can be open to interpretation.
Volatility can mean many different things. As a trader, you can say “the market is volatile,” and you would be referring to the excitability and unpredictability of the market movement. When discussing options you could ask “What’s the volatility in July?” There you would be asking for the implied volatility of the at the money strike. In other words, plugging in all knowns, including market price, into an options model and solving for volatility. On TV we hear pundits discussing the VIX, and they often call it the fear index. Maybe some of them even know that what they are quoting is the at-the-money option volatility of the front month S&P contract. That’s the extent of the knowledge most people have about volatility.
But skew is the real game.
When you compile the volatility of each strike, and plot that on a graph you get the overall skew. Aside from at-the-money, you also divide skew into the upside skew (call skew), and downside skew (put skew). The volatility at any given strike is seemingly answering the question ‘“what will the new at-the-money volatility be, if prices were to move to this level?” (This isn’t the only way to look at this, but other explanations will be explored in another blog).
Skew shapes can vary by market, as each market has its own unique dynamics, and risk tolerances. Let’s consider the stock market. The skew is always negative, or flat to the upside, as the normal conditions for the market is a slow grind higher. Everyone is long stocks, as they are invested in many companies, and everyone profits off moves higher in the market. There is little risk in a move higher. However, because everyone is long, and profits on rallies, they are fearful of a break, and they want to protect against that risk. Put skew is high, as the market anticipates that volatility will increase on a break. People will liquidate stocks, selling will beget selling, market breaks are usually fast and furious.
So what’s the point? When the S&P is down 100 points and you hear the pundits say that the vix is up 10 points, the question I always ask myself is how much is skew, and how much is an actual increase in volatility? Often, I’ll go to the S&P options board and see that actual volatility is up only 1 point, but that the majority of that “increase” is simply the price moving lower, up the negative put skew. That’s not to say that the volatility isn’t higher, it is, but it hasn’t moved up, we just moved to a strike where we had already priced in a more volatile market.
Most new, and even some experienced options traders don’t understand this single concept. This is why options trading is so hard and why so many people lose money. As prices move, at-the-money volatility shifts, and skews adjust. Options may not perform the way you expect them to, or even the way your model tells you they will! The market is overall efficient. It anticipates volatility. Options traders know where the risk lies, and they build it into their models, not just through their assessment of risk and volatility, but through their interpretation of call and put skew.