Many option traders have discovered and taken advantage of the interesting fact that implied volatility for options on a particular underlying instrument can vary considerably depending on the option’s strike price.

In addition to providing trading opportunities, this variation also helps option market makers account for any future risks that they perceive may result in increased volatility in the underlying instrument’s price upon a directional move.

Furthermore, it allows option dealers to adjust their implied volatility pricing for supply and demand factors that may otherwise cause imbalances in their option portfolio that can increase its overall risk on a directional move in the underlying.

Plotting the Implied Volatility Curve

The aforementioned volatility variation phenomenon can be suitably illustrated by plotting an implied volatility surface diagram that shows how implied volatility varies across a range of strike prices for a particular expiration date.

Furthermore, to obtain the most interesting graph, these strikes should be selected both above and below the current At-The-Money or ATM option strike price to best depict how the market currently perceives the risk involved in a rise or decline of the market from its current levels.

Figure 1: This diagram plots the implied volatility of a set of options of the same expiration date on the y-axis versus their strike price on the x-axis.

Note from the above diagram that when the implied volatility of options is plotted in a two dimensional diagram against strike price, an implied volatility “curve” is created.

This curve can be used by professional option market makers to price options which are not actively traded on an exchange by interpolating the implied volatility to fit the strike price of the desired option for the given expiration date.

Furthermore, in looking at an implied volatility curve for a particular trading instrument and expiration date, several features may become apparent that are covered in greater detail in the sections below.

The Implied Volatility Smile

The first common phenomenon observed from implied volatility curves is that the implied volatility of OTM option strike prices may trade substantially above the implied volatility for ATM options.

This phenomenon is often referred to as the implied volatility “smile” since the graph of implied volatility versus strike price tends to curve up at the edges a bit like a smile.

Option market makers use this pricing technique to correct for the so-called “fat tails phenomenon”. This is observed in market price action when unlikely events tend to happen more frequently than the Black-Scholes or Garman-Kohlhagen option pricing models would tend to predict.

Furthermore, although the bid implied volatility for OTM options may not change very much in practice from the ATM bid, the offer volatility — and hence the bid-offer average volatility — will often rise considerably versus the ATM volatility when a volatility smile is present in option market pricing.

The Implied Volatility Skew

The second interesting phenomenon that can be observed from implied volatility curves is that the implied volatility for OTM put or ITM call options struck below the current ATM option price may trade at a different level to that seen for similarly OTM call or ITM put options struck above the current ATM price.

This difference is commonly known among option market makers as the implied volatility “Skew”. Nevertheless, some traders reserve the use of this term for when the lower strikes trade above or below the ATM strikes, while the higher strikes traded below or above the ATM strikes.

In either case, the skew often reflects the supply and demand effects observed when a trend is occurring in the underlying exchange rate that favors the direction of the strike prices with the higher implied volatility levels.

Currency option markets will tend to demonstrate fairly similar implied volatility levels for OTM calls and OTM puts of the same delta unless a strong trend is occurring. In this case, the skew will tend to increase to price the OTM options in the direction of the trend at a higher implied volatility.

Thus, if the market in a currency pair is trending higher overall, then OTM calls will tend to trade at a premium to OTM puts, for example. Conversely, when the underlying market is trending lower, then OTM puts will usually trade at a premium to OTM calls.

On the other hand, equity markets often feature a marked implied volatility premium for the OTM puts versus the OTM calls that often trade at a relative volatility discount.

This notable equity option market skew is often attributed to the tendency of equity portfolio risk managers to purchase OTM puts to protect their equity holdings and to sell covered OTM calls against their equity positions to cap their profits.

Such equity hedging behavior tends to create a supply and demand effect that raises the implied volatility of OTM puts over that seen for OTM calls.

Quotations Reflecting Implied Volatility Smiles and Skews

Option market makers will often quote the skew as a so-called “Risk Reversal” premium of OTM calls over OTM puts of a particular delta. They might also reflect the skew in their implied volatility quotes for a Butterfly strategy — also known as the “Fly” for short.

Professional option traders tend to quote Risk Reversals by making a market for the “X% Delta Risk Reversal”. The value of this volatility neutral spread is computed by taking the difference in implied volatility between where they would:

  • Buy the Risk Reversal: This means where they would buy the X% Delta Call and sell the X% Delta put simultaneously,

or

  • Sell the Risk Reversal: Where they would sell the X% Delta call and buy the X% Delta put.

Along similar lines, a Butterfly strategy might be quoted by a market maker as their bid and offer for an “X% Delta Fly”. This would mean the market maker’s implied volatility levels where they would:

  • Buy the Butterfly: This involves them buying the X% Delta OTM Call and the X% Delta OTM Put and selling the ATM Call and Put,

or

  • Sell the Butterfly: This involves them selling the X% Delta OTM Call and the X% Delta OTM Put and buying the ATM Call and Put.

Currency option market makers tend to focus primarily on the Risk Reversal in their quotations that reflect the implied volatility skew, while traders in other markets may prefer to use the Fly.

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Every good trader has a set of rules that he or she follows, that they have found work for their trading style, and personality type. Trading without rules is trading without discipline, and trading without discipline is more often than not trading without much success.

I have found that being disciplined about my entry and exit points of trades has made me more successful than the actual “picking” of winning stocks. Discipline is the tool that allows me to consistently cut my loses before they are able to do significant damage, while simultaeneously locking in gains from successful trades.

The List.

1. Never fight the major market trend: In up trending markets, one should be buying. In down trending markets, one should be selling. If you can’t really decide the direction of the market, you shouldn’t be trading. Liquidate all your positions to cash, and wait for an opportunity that you are comfortable with to present itself.

2. Buy at support and sell at resistance: Never buy a stock that is over extended from a proper base, and never sell a stock at a support level.

3. Before making a trade, setup predefined entry: Before entering any trade, go through all of the possible scenarios that would you sell the stock. How much profit is enough for you to take the gain? How much of a loss are you willing to take before you liquidate the position. These are the kinds of things that help take some of the stress out of market involvement. The more outs you give yourself, the more sucessful you will be over the long run.

4. Never hold a position through an earnings call: Earnings conference calls can be the times when stocks are the most unpredictable. Earnings can have a positive suprise, and the stock price can still tumble due to small things that come in excess of the raw numbers.

5. Never add to a losing position: NEVER EVER EVER EVER EVER EVER (Get the picture?) add to a losing position. Adding to a losing position creates a scenario emotionally where you are trying to make back money that you have already lost. This is never a good idea. Chasing a trade is a big no no.

6. Never risk more than 10 per cent of your trading capital on any one position: 10% is a personal preference. I know some traders that never put up more than 5% on any one position, and some that are willing to risk as much as 20%. How much you are willing to risk will be determined by your risk tolerance, and what your investment goals are.

7.Take responsibility for your own trades: Any trade that you make are your own fault. You must learn to be accountable for both your successes and failures. If you blame your mistakes on external factors… then where do your successes come from. If you can’t, or don’t want to be responsible for your trades,don’t make them.

8. Never allow a winning trade to become a loser: If you ever make a trade that yields you a quick profit, adjust your stop loss so that you can lock in some of that gain, or sell some of your stake so that you can be sure to take advantage of your success. In most cases, winning trades become losers through mismanagement and lack of discipline.

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Upgraded from this…

To this…

I love markets!

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I think i’m off to a pretty good start… you be the judge :)

These are the results from one of the automated trading systems that I am in the process of beta testing. Clicking on the picture of the equity curve will take you to the detailed trade statement. The next step is to link it with the blog so that it will update in real time and continue to improve entries and exits. Onward.

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Market internals are quite strong today. We are at the highs of the trading session. 451/36  Advancers to decliners on the S&P 500. Buying volume is 10 times selling volume.

There is a definite return to risk taking today. The only thing that is concerning to me is the VIX is only down 1%… That doesn’t seem like a confirming signal to me.

Euro, Aussie are trading broadly higher, British Pound mixed, US Dollar lower, Yen lower

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Long 10000 USDCAD @ 1.05206

Short 10000 USDCHF @ 1.07888

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Long 10000 EURUSD @ 1.36001

Short 10000 NZDUSD @ .69755

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Long 10,000 EURUSD @ 1.36001

Short 10,000 AUDUSD @ 1.05206

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Portfolio Exposure

In: Trades

12 Feb 2010

+20000 EURUSD @ 1.36739

-10000 USDCHF @ 1.07177

+20000 GBPUSD @ 1.56618

+10000 USDCAD @ 1.05131

-30000 AUDUSD @ 0.88854

-10000 NZDUSD @ 0.69719

Portfolio Exposure

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Long 10000 USDCAD @ 1.05131

Short 10000 USDCHF @ 1.07177

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About TheStocksBook

My name is Robert Spence and this is my blog. I am currently a student at the University of Pittsburgh studying Economics. This site is devoted to my development as a trader. I have been trading U.S. equities and options since 2005, and FOREX pairs since October 2008. My goal is to run my own Global Macro Hedge Fund in the not so distant future.

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