If you've never looked at an entire chain of options (all months and all strikes) for one underlying and their respective implied volatilities, you might be shocked to find out that all options are not created equal when it comes to implied volatility (IV). Note that we're specifying "implied" volatility not historical, because IV is directly related to the option price. The only way to calculate IV is to take the current premium of the option contract and solve for the implied using one of several options pricing model like Black-Scholes. (Check out this post for more.)

Puts versus calls

First let's address ITM, ATM and OTM IV; then we'll look at different time frames. When comparing IV you will notice that in most cases the OTM puts will trade for higher IV than the OTM calls. This anomaly has developed over years and years of option trading, and there are plenty of rational reasons that help explain it. One that has always struck me as sensible is that puts are very commonly used as protection or a hedge against a downward movement in a stock. Index options can be used to hedge an entire portfolio.

When you're thinking in terms of hedges or protection, options start to resemble car insurance in many ways - a comparison I've made in this blog before. When you purchase car insurance many will buy the $500 to $1000 deductible because it ‘s more affordable than zero-deductible insurance - the same is true in the market. OTM puts cost less than ATM options simply because they have further to go before they hit a payout, much like hitting your deductible. The demand for cheap insurance (or cheap OTM puts) can increase prices. Toss in the fact mentioned in last week's post that declining markets have a tendency to move faster and farther than when markets increase, and you can start to see where I'm going with this.

No matter what the reason for this skewing of IV's, it's real and you should stay aware of it. For example, take a look at the chain of February options on the the S&P 500 Index (SPX). As of Friday 2/1/08's close, it was at 1395.42. As you'll see in the red box the IVs gradually increase on the put side as we get further OTM; compare that to the gradual decrease on the call implied when we get further OTM. Please double click on the picture to see an enlarged view of SPX February Option Chain.

Who cares? All those OTM put hedgers.

This all might sound academic now, but if you're out there trying to buy OTM puts it's a real issue. Check out the put that's 50 OTM or the 1345 strike (9.50 x 10.10); compare that to the call that is 50 points OTM or the 1445 strike (4.30 x 5.10) . The ask of the put (10.10) is almost double of the ask of the call (5.10).

Moral of the story: being bearish on the market isn't cheap. In last week's post I mentioned if you're going to buy an OTM option (put or call) and be right about the direction of the marketplace before expiration, being right with puts may reward you more then being right with calls. This is because of the inverse relationship IV usually has to the marketplace - that is, when markets go down IV usually goes up. This week I wanted to be sure to balance out the picture on puts: those OTM puts may be more expensive initially, for the reasons discussed above. This skew in IV anomaly might not be the case every time, but the bulk of the time it'll hold true.

Next week we'll discuss volatility tilt between different expiration months and what that usually means. Stay tuned!

Regards,
Brian (OG)

[image: See-Saw by pittsinger on flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.

I am a little confused by this question. I assume you are talking about a long straddle and you are saying after the news you have had instances where the stock went down and the value of the straddle did not go up. I would say if anything this post implies that as stocks go down implied volatility increases. There is usually a volatility "crunch" around an earnings report, but I think the crunch is more often worse when the stock goes up then when it goes down.

Regards,
Brian (Og)

Hello Paul,

After reading your forum you started on straddle prices I now understand your question better. Hold on to your hats for this one, this is going to be really hard to explain in a forum post. The answer is in the delta; the truth is that the ATM call and put are really not ATM as far as pricing models are concerned. If you have an example of a Long ATM (stock is right at the long straddle strike) straddle, notice the position delta for the call is much larger then the position delta for the put when in the P&L Calculator, also the price paid for the call is almost always more then the price paid for the put. Now, because the call delta is larger then the put delta you are rewarded more of an upward movement then a downward movement. A "more" advanced answer and real rational as to why this happens. In option pricing calculators there is an interest rate and dividend number that is inputted into the model. What a model does to start with is forward value the stock (stock price plus carry costs or interest paid to hold the position, less any dividends paid by the stock). This is where the true ATM straddle is located. So if the stock is at 50 the forward might be 50.50 this would mean the call is actually 50 cents ITM as far as the option pricing model is concerned. So if you could find a long straddle with the strikes right at the FORWARD price of the stock the P&L calculator should have equal breakevens to the upside and the downside on day one. How do you find this you ask... look at the delta. If the call delta is truly .50 the put delta should be negative .50, which means they would add to one if you ignore the negative sign. Now this is in a theoretical world in reality they will be close to one but not exactly 50. This is a great blog that explains why the call trades for more then the put. http://community.tradeking.com/members/optionsguy/blogs/2061-early-exercise-part-3

Regards,
Brian (Og)