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Implied volatility is a very important factor when designing option strategies, which makes it a very important element for trader to consider before initiating a position. One way of looking at implied volatility is to look for volatility skews. The different types of skews include volatility price skews and volatility time skews. Volatility skews occur when two or more options on the underlying stock have a sizeable difference in terms of implied volatility. Volatility price skews are between differing strikes with the same expiration and volatility time skews occur between different months of the same strike.

Implied volatility skews can actually be plotted on a chart to form different shapes that have different trade implications. The various shapes implied volatility can take on a graph include the volatility smile, volatility frown and the volatility slope. The volatility smile shape is when higher volatility options occur above and below the lower volatility at-the-money and near at-the-money options. When lower volatility options occur above and below the higher volatility at-the-money [ATM] and near at-the-money options you have a volatility frown. Finally, a volatility slope is generated when higher volatility options slope down to lower volatility as strike price increase or slope up from lower to higher volatility as strike prices increase.

The volatility smile is typically the post popular of the skew graphs and is usually discovered during times of high volatility. The higher the volatility, the steeper the skew is likely to be. The volatility smile demonstrates that there are discrepancies in both the in-the-money [ITM] and out-of-the-money [OTM] options. Figure 1 graphically depicts an example of a volatility smile. If the trader is bullish on the underlying stock then a volatility smile would allow them to create a bull call spread by purchasing the lower strike calls and selling the higher strike calls.

On the other hand, if the trader has a bearish bias a credit spread like the bear call strategy would be appropriate using the higher strike calls to sell and hedging them with the lower strike calls. The key point to keep in mind when experiencing a volatility smile is that the option strategist wants to be sure to buy low implied volatility and sell high implied volatility.

The opposite of the volatility smile is the volatility frown, which shows differences in both the in-the-money and out-of-the-money options with low volatility options above and below the ATM and near ATM strike price. If the trader is bullish in this case they could just purchase OTM calls. If the trader were bearish a bear call strategy where the trader would receive a net credit would be a suitable strategy. This type of skews does not occur very often much like the volatility slope.

The volatility slope is a skew where it is going in one direction. For example, higher volatility options slope down to lower volatility as strike price increases and vice versa. This type of shaped skew is almost always found in an index market and rarely discovered in a particular equity. These different type skews formations are important concepts for the effective options strategist to comprehend. However, regardless of the particular shape and option strategies being traded always make sure that you are always a net buyer of low implied volatility options and a net seller of high implied volatility options.    

Figure 1: Example of a Volatility Smile for both Calls and Puts
(Courtesy of Optionetics.com)

Happy Trading.


Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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