Use Volatility Skews to Gauge Trader Sentiment

Volatility skew can also explain odd moves in option pricing

   

Analysts are always trying to determine and understand the ever-elusive concept of trader sentiment. After all, when you get right down to it, it is traders who move the market. Sure, these traders are influenced by economic reports, fundamental indicators and technical analysis, but in the end, it is people who are making the trading decisions. It therefore stands to reason that if you could better understand what trader sentiment is at the time, you could better anticipate how traders are going to respond to new information.

Luckily, as options traders, you have access to a few key pieces of information that can help you determine how other option traders feel about specific stocks at any given time.

You can get a good idea of whether trader sentiment is bullish or bearish toward a stock by looking at the Call/Put Volatility Skew (the difference in the implied volatility levels between call and put options). All you have to do is look for the following:

When the ratio is greater than one (>1.00), it shows trader sentiment is bullish toward a stock.

When the ratio is less than one (<1.00), it shows trader sentiment is bearish toward a stock.

Of course, you probably shouldn’t put too much emphasis on a call/put volatility skew of 1.01 or 0.98, for example. Slight variations like this in the skew are most likely an indication of a little noise in the option prices, not a significant indicator of sentiment. Instead, you should focus on numbers that are farther away from 1.00 – like 1.26 or 0.81. The farther away from 1.00, the more conviction you can have that traders are actually bullish or bearish.

How Volatility Skews Form

Volatility skews form when demand for calls exceeds the demand for puts, or vice versa, even if the underlying stock’s price is not moving very much.

You see, when demand for an option increases, the laws of supply and demand indicate that the value of the option has to go up. But which component of the option’s price is increasing in value, the intrinsic value or the extrinsic value? Well, because increased demand for the option doesn’t change the price of the underlying stock, it can’t be the intrinsic value. So it must be the extrinsic value that is increasing.

But how does a market-maker change the extrinsic value of the option? It’s simple. He just increases the implied volatility for the option, and the value of the option magically moves higher.

Did the underlying stock move? No. Did time move backwards and suddenly give the option more time value? No. Did interest rates change? No. The only thing that happened was the price of the option increased to bring demand in line with supply, and that resulted in the implied volatility number being raised. That’s the key.

Changes in implied volatility levels tell you whether demand is increasing or decreasing. Knowing this, you can compare the changes in implied volatility between the call and put options for a stock and get a pretty good idea whether trader sentiment is bullish or bearish for that stock.

Now that you understand how volatility skews form, let’s take a look at how you actually calculate the skew.

Calculating the Call/Put Volatility Skew

To find the call/put volatility skew for a stock, all you have to do is go to the free IV Index tool on the CBOE’s website (www.CBOE.com). To find the tool, hover over the Tools tab in the top navigation and then click on Volatility Optimizer. Once this page comes up, click on the IV Index link under the “Free Services” heading. You can also find the tool by clicking here.

Once the tool comes up, type the ticker symbol of the stock you are interested in into the Symbol field. We’ll look at J.C. Penney (JCP) for our example.

Once the data comes up, look for the Current values of both the IV Index call and the IV Index put — which are 57.81% and 60.22%, respectively, for JCP.

SST821 Use Volatility Skews to  Gauge Trader Sentiment

Now, simply divide the IV Index call number by the IV Index put number, and you will have your call/put volatility skew number, which is 0.95 (57.81 ÷ 60.22 = 0.95) for JCP.

Note: While the call/put volatility skew is an important piece of information, it is not the only piece of information you should consider when trading options. It should be a piece of a larger framework of data and analysis.


Article printed from InvestorPlace Media, http://investorplace.com/247trader/use-volatility-skews-to-gauge-trader-sentiment/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.