A real-world example on the impact that skew can have on an options position
By Craig Bewick, Senior Director, Retail Sales
The research views expressed herein are those of the author and do not necessarily represent the views of CME Group or its affiliates. All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience.
One of the first concepts new options traders should be aware of is implied volatility (IV). If you search for the definition of implied volatility, the most common search engine result is “implied volatility represents the expected volatility (or price movement) of the underlying instrument over the life of an option”. Because IV represents the market consensus of what the price volatility of the underlying instrument will be it is indeed a very important concept to understand. Ceteris paribus, the higher the IV of an option, the more expensive or the higher the premium a seller will charge for that option and vice versa.
While IV is often described as an input to a standard pricing model, we prefer to think of it as an element that “falls out” or is derived from a pricing model. Of course, if one was performing a theoretical or academic exercise to determine the theoretical value of an option, they would, indeed, typically input an IV level into the model they chose in order to generate a theoretical value. Most options models incorporate the following inputs:
- Strike price of the option: Chosen by the trader (known)
- Days until expiration: Chosen by the trader (known)
- Price of the underlying instrument: Determined by the “market” (known)
- Interest rate: Generally, the accepted “risk free” rate (known)
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