The Volatility Surface: Skew and Term Structure

In one of the final sessions of Day Two, Sheldon Natenberg, Co-Director of Education, Chicago Trading Company, and Natasha Jhunjhunwala, Director, Equity Derivatives Product Management, Credit Suisse, presented on “The Volatility Surface: Skew and Term Structure.” Natenberg is the author of “Option Volatility and Pricing,” one of the most widely read books by option traders around the world. Jhunjhunwala said she was honored to be sharing the stage with a “derivatives legend.” Despite being the last session of the day, the room was jam-packed.

Natenberg’s first slide said: “Traders have long noted that implied volatilities vary across both expiration date (the term structure of volatility) and the exercise price (the skew). When taken together, the term structure and volatility skew form a volatility surface.”

Some highlights:
– most underlying contracts have a typical/average volatility which they tend to revert to over long periods of time
– term structure is important for risk management
– volatility tends to be mean reverting
– short-term implied volatilities almost always change more quickly than long-term implied volatilities
– long-term implied volatilities tend to remain close to the mean volatility
– term structure of volatility has important implications for implied volatility products such as VIX
– volatility skew: the tendency of options with the same expiration date, but with different exercise prices to trade at different implied volatilities

He then listed some assumptions on which traditional theoretical pricing models are built:
– price changes are normally distributed
– volatility is constant over the life of the option
– trading is continuous, with no gaps in price of the underlying contract
– volatility is independent of direction in which underlying contract moves
In demonstrating some trading examples, Natenberg said “in order to model risk, a trader will want to consider how market conditions will affect the location of the skew and the shape of the skew.” It was noted that volatility skews are often described in terms of their tilt (skew) and their curvature (kurtosis). Some trading examples of each were shown.

Jhunjhunwala talked about different ways to look at skew and how traders can read the information within the volatility surface. Key points included:
– different measures of skew represent very different information sets
– both skew and term structure offer forward looking information about the volatility surface
– skew and term structure are typically highly correlated, excepting for some anomalies, such as Japan 2013

In talking about using skew as an indicator of market risk, she noted that it has, historically, signaled periods of high risk. The Credit Suisse Fear Barometer is an alternative measure of skew. She said a high level of the CSFB indicates an increased demand for put protection and a decreasing value accorded to call options. The CSFB is typically higher as the market rises and is lower on market lows.

She discussed trading the volatility surface:
– Long Skew: implemented through delta hedged options offers attractive features for hedging tail risk
– Short Skew: may be implemented through exotic variance swaps and offers a carry trade slightly different than typical short volatility trades
– Term Structure: can be seen as a market with its own unique properties

Highlights from Day Three of CBOE RMC Europe coming tomorrow…