Friday, March 23, 2012

Implied volatility distortions for short-dated calls are not real

Someone sent us this Bloomberg chart that shows the SPY (ETF) equity option "skew" (implied volatilities across different strike levels) for options with a 1-month maturity. Strike price is shown as a percentage of the current price of SPY. It looks as though the implied volatility on the up-side has spiked dramatically. One explanation proposed has been that as the equity rally stalled and people have sold some of their equity positions, they also bought back the covered calls they shorted earlier - bumping up implied vols.

1 month SPY SKEW: Today, 3 days ago, 1 week ago

But there is a simpler explanation. The deep out-of-the-money options for a 1 month maturity are quoted at a couple of pennies but there are no trades at these levels. As SPY sold off a bit during the week, the options were still quoted at roughly the same levels and there were still no trades.

Call option quotes (Source: Bloomberg) 

Now if options are "priced" at a constant level while the underlying drops, the implied volatility will increase. When options are quoted in pennies and little or no trading takes place, seeming distortions in implied volatility become common. But it's hardly an indication of anything fundamental going on in the market. With the 3-month maturities for example, where option premiums have real value, this distortion no longer exists.

3 month SPY SKEW: Today and 1 week ago (Bloomberg)
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