Options trader Alan Ellman of TheBlueCollarInvestor.com explains how your knowledge of skew and smile patterns can help you better understand the relationship between implied volatility and option premiums, thus better help you assess potential risk in the future.

In covered call writing, our option premiums are influenced by the volatility of the underlying security. Using the Black Scholes option pricing model, we can calculate the volatility of the underlying by entering the market prices for the options. Common sense would seem to dictate that for options with the same expiration date, we expect the implied volatility (IV) to be the same regardless of which strike price we use. However, in reality, the IV we see is different across the various strikes. This disparity is known as the volatility skew. Let’s first review some key definitions:

Implied Volatility - This is a forecast of the underlying stock’s volatility as implied by the option’s price in the marketplace. This differs from historical volatility:

Historical volatility: This is the actual price fluctuation as observed over a period of time.

As discussed in my books and DVDs, an options pricing model such as the Black-Scholes model uses six inputs to determine the theoretical price of an option:

  • Asset Value

  • Time Left Until Expiration

  • Strike Price

  • Risk-Free Interest Rate

  • Dividends (if applicable)

  • *Asset Volatility

Option premiums will rise and fall with volatility. These pricing models make the incorrect assumption that volatility is constant throughout each respective strike price and regardless of duration. Supply and demand will never allow these conditions to exist. It is, however, possible to calculate IV for different strike prices and over different time frames by using the current options price as a given, using the other five inputs listed above and then solving for that specific IV. The difference in implied volatility levels for options with the same underlying security is known as volatility skew. Stated differently, it is the difference in IV between out-of-the-money, at-the-money and in-the-money options and also different expiration periods.

NEXT PAGE: Different Types of Skews