Volatility Smile and Shift from Spot

[Archidamus]

I'm currently looking at crude oil futures, and see that the volatility smile is at a minimum about 2% above the spot price, and the chain in question is 30 days from expiration. Could someone give me an intuitive reasoning why the volatility skew is not centered on the spot price, or even forward price?

 

[StephenKim]

I'll take a stab at this. I'm not sure of your background so I'll provide two possible reasons.

For many asset classes (i.e., options on indices and options on some FX pairs), the volatility "smile" isn't really a smile where the lowest implied volatility is for ATMs. For some asset classes - the volatility "smile" is more of a "smirk." Like for equity indices, the probability of a large downward percentage loss is much greater than the probability of a large upward gain. (How many times has the market lost 10% in one day. How many times has the market gained 10% in one day.) So that asymmetry is reflected in the implied volatilities of options on equity indices. So if the volatility smirk or smile persistently has that shape for a given expiry for that asset class, that could be one possible explanation.

If you're saying that the shape of the smile (or smirk) itself for Crude Oil Futures has changed in the very recent past (like in the past few days), I'd say that that is likely the impact of Hurricane Florence, and concerns over its impact on crude.

 

[Archidamus]

Stephen, the skew/assyemetry makes sense, especially with equities and event risk to the downside. But even SPX options exhibit the off centered shape, of having the minimum IV 2-3% above the current price. Below is a rough sketch of what I'm seeing.

Is it just from empirical data that market makers are doing this, or is it founded in theory? My guess is that its empirically driven.

 

[StephenKim]

Hello Archidamus,

Implied volatility is, by definition, empirical. It’s the way option market makers get around the various shortcomings of the Black-Scholes model.

 

[Archidamus]

Awesome! that answers my question precisely, thanks.

 

[StephenKim]

Glad to help.

There is a quote about implied volatility and how it adjusts for some of the shortcomings of the Black-Scholes model. The quote is attributed to Rebonato, "Implied volatility is the wrong number you put into the wrong formula [Black-Scholes] to get to the right price [prices observed in the market]."