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Technical Update: Implied Volatility Skew

  • Written by Syndicated Publisher No Comments Comments
    January 20, 2012

    I have not posted a skew chart in quite a while. Admittedly it was getting difficult to draw conclusions from some of the wild price action. That was until the past few days when the skew literally shot out of a cannon. While the vix remains in a descending wedge and narrowing in daily price fluctuations the skew has blown out.

    Implied volatility has a theoretical bell curve distribution. At times though investors seek further out of the month versus at the money options which drives up the IV and thus “skews” the distribution. This often precedes a move in the vix where investors are buying speculative, tail risk options which once markets begin to move lower are no longer tail events and begin showing up in at the money options as measured by the vix.

    Excuse the color selections on the chart below (little limited with TOS tonight) but notice the amazing correlation over the past year with the skew (shaded gray) and the SPX (red line). What’s most notable are the spikes in the skew and how they correspond with tops in the market.

    Conceptually this makes sense as once markets reach a level investors feel warrants the purchase of out of the money options they begin buying those in earnest. As markets begin moving even higher the buying accelerates causing the skew to spike higher. Once the markets begin to selloff “less savvy” investors begin buying at the money options as measured by the vix causing it to then rise.

    When you put this jump in the skew in perspective with a descending wedge on the vix the probability of a major vix breakout becomes even higher.

    Images: Flickr (licence attribution)

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