Editor's note: The labels on the table in this column have been corrected.
We have touched on the "skew" in options before, now let's talk in a little more detail about what causes it and what it means. I will use GM options as an example; I do have a position in these options. The stock price is $36.20:
The skew means "the difference in the implied volatilities between the various strike prices of the options". Notice that the implied volatility of the 45 strike put (24% in the money) is approximately 8.5 volatility points less than that of 30 strike put (17% out of the money). In arbitraging options we don't care much about being in the money or out of the money (notice there is about the same time premium and vega in both; this is what counts), just how far away from the strike they are. So this is the skew: 8.5 volatility points for 41% differential in strikes ((45-30)/36.2). Why does this anomaly exist and what does it mean?
Traders use options to speculate, but by far the largest group of investors that determine option relative prices are hedgers. Hedgers predominately do two things: they sell out of the money calls or buy out of the money puts (both hedge, albeit differently, long stock). When a hedger sells out of the money calls, it affects directly the implied volatility of the same strike put; if it didn't, an arbitrager would come in and buy the call and sell the put (thus creating synthetic long stock) and sell the physical stock short in the same amount and create a risk-less profit. So a constant supply of out of the money calls creates relatively cheap in the money puts (same strike). At the same time, there is a constant demand for out of the money puts by hedgers, driving up the implied volatility of these strikes. The more hedgers want to hedge, the larger the supply/demand imbalance of these strikes and the larger the "skew" or difference in implied volatilities.
In order to answer the question of whether or not the skew should exist, ask yourself the question: should the stock be more volatile at the lower strike than the upper strike? In some cases the answer is yes: there may be an event that could send the stock down precipitously through the lower strike, whereas if it did not come to pass it would not send the stock much higher. The answer might also be yes, but the relative prices might be steep relative to expectations. In the above example I will tell you that the skew was much steeper several months ago, but still steeper than most stocks. The skew plain and simple exists most prominately where hedgers are active.
This is another warning sign for the market. If I look across the spectrum of stocks that I follow I notice that the skew is much flatter than it was several months ago and almost non-existent in many stocks. This indicates a lack of hedging activity and complacency.
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