We already know that the Volatility is the uncertainty in the market and that higher the uncertainty, the more likely it is for the stock to move on a daily basis. We also know that Implied Volatility will be elevated before earnings and it will go down after earnings.
Figure 26 depicts the Implied Volatility for OTM Puts versus OTM Calls. If the stock is trading at $45.43, then the two OTM Puts are 33 and 24 when the Implied Volatility is elevated. For January, the Implied Volatility is at 87-80 level, but for the same Expiration months, the Implied Volatility for OTM Calls is much lower. This is what Volatility Skew means. For the same equidistant price from where the underlying stock is trading, OTM Puts have much higher demand than OTM Calls, meaning that their Implied Volatility is elevated.
You can also see that the Front Months Implied Volatility versus the Back Months Implied Volatility is also different. The Implied Volatility for August is higher than the Implied Volatility for November, and the Implied Volatility for June is higher than that of July. This is due to some kind of binary events that are happening in the market. It’s important to understand the existence of Volatility Skew: that there can be higher demand for OTM Puts than OTM Calls, or that the Implied Volatility for the Front Months can be higher than the Implied Volatility for the Back Months.
• Often, higher demand for Puts indicate that there is a higher difference in Volatility. This means that even if the market sells off, there will be more demand for the Puts and hence the Implied Volatility for Puts will be higher.
• Large horizontal Volatility Skew between two months allows you to create strategies such as Calendar Spreads that benefit from time decay.
• The Implied Volatility in a Front Month is outsized to the movement due to binary events such as earnings.
• Calendar Spreads are buying strategies that are beneficial when the Implied Volatility is lower and Options are relatively cheaper.
• This provides an opportunity to buy options at a cheaper price and take advantage of Volatility potentially increasing thereafter.
• When trading Calendar Spreads, you benefit if the Implied Volatility rises.