Options traders commonly use the term “skew”. Options with different strikes and the same expiration date typically have different implied volatilities. When we plot those implied volatilities against the options’ “moneyness” (the percent of the underlying share’s price that the strike represents), we typically see a non-linear graph. That curvature is what gives rise to the term “skew”.
Skew can be explained by fairly typical trends in trader psychology. It is quite normal to see the lowest implied volatilities in slightly out of the money calls. The buy-write strategy is quite common, so there is a natural supply of those calls coming into the market. It is also quite normal to see the highest implied volatilities in out of the money puts. There is a constant demand for put protection and the steadiest source of that protection comes from market makers and other professionals. Those sellers are highly price sensitive, and require the incentive of a volatility premium to offer that protection.
The IB TWS offers robust tools for skew analysis. They can be found under the “Analytical Tools” tab -> Option Analysis -> Volatility Skew. I have utilized them in prior pieces for Traders Insight. The analyses that I will be utilizing throughout the remainder of this article require greater history than is available under the Time Lapse Skew function, however, so I will utilize Bloomberg for the graphs displayed below.
The following snapshot of QQQ shows how skews can change over time and under different market circumstances:
Using percentages of moneyness rather than outright strike prices greatly simplifies comparisons of historical skews. This way we don’t have to wonder where the price of the underlying stock was at any given point in time. Today’s skew for options expiring 1 month from now is the red line that is generally near the top. That means that the level of implied volatility is quite high on a relative basis throughout the curve. We can see that it is relatively parallel with the magenta line at the bottom. That was a snapshot taken in February, when markets were also roaring ahead and the Covid-19 crisis was not in the market’s mindset. The conclusion that we can draw is that the general enthusiasm for the market’s continued advance is similar, though there is generally much more nervousness across the board in the current environment.
Compare those lines to the blue line, which was a snapshot from early March, when markets were tumbling. At-money and below-money prices of options were similarly priced to those seen now, but there was far less demand for above-market options. One would call that a very steep skew, when one set of options has far higher implied volatilities than another. That skew was steep in March is unsurprising, just as it is unsurprising to see a flattish skew in February and now. The more interesting finding is that the general level of volatility is so high now. To my mind, this displays overall concerns about risk in both directions – there are investors who are long the NASDAQ leaders but uncomfortable with the speed of the rally, while others are willing to speculate with options about its continued advance.
Bearing those graphs in mind, compare them to this graph of Apple (AAPL) over the same dates:
Yes, AAPL has an inverted skew! Traders are so intent on the idea that Apple could continue to rally that they are bidding upside calls to levels above those of downside puts. It is unsurprising to think that Apple’s dramatic rally would push call writers to the sidelines, but the risk/reward calculus among AAPL investors has flipped. Despite, or perhaps because of the nearly vertical move in AAPL, traders would rather speculate that it can continue over the next month than hedge themselves against a potential decline. This is most unusual, especially when we consider that AAPL is the world’s most highly valued public company. For now, the market perceives greater risk in missing an upside move than losses should its eye-popping rally stumble.
Compare Apple to Amazon (AMZN). We see a very flat skew in AMZN as well, though it is not inverted like AAPL. Yet again, traders fear missing a rally almost as much as being caught in a downdraft:
Of course, when analyzing truly unusual skews, I can’t resist bring the most unusual of all into the discussion. Here, for your perusal, is Tesla (TSLA):
Tesla has typically displayed a flat skew, which is unsurprising when we consider the rampant enthusiasm that its ardent proponents have displayed for years. But, like AAPL, TSLA has gone to an inverted skew in the aftermath of its stock split.
These examples, among others, lead us to a conundrum. We can say that we are seeing a market that is both risk-averse and highly complacent at once! Investors are paying high prices for options across the board, meaning that they see the potential for risks ahead. But the nature of that risk is unusual. Many clearly view the risk of missing an upside move (aka FOMO) as similar to, if not less than, the risk of a correction to market leading stocks, if not the market as a whole. That is a highly unusual circumstance, and it raises the possibility that markets will be difficult to navigate in the coming weeks.
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