Jared Woodard and Brandon Henry evaluate different implied volatility skew formulas and expalin their practical uses in investor's portfolios.
The presence and significance of
implied volatility skew is one of the most important and
interesting aspects of listed options. Implied volatility skew
refers here to the differences in the implied volatilities of
options in the same expiration cycle with different strike
While there are many competing attempts in the literature to
model the behavior of changes in skew, these models should not
be confused with explanations: the reason why skew exists, in
options on any asset, is that market participants are only
willing to trade contracts at some multiple of implied
volatility above or below at-the-money levels. That participant
order flow is the singular cause of volatility skew is
practically a tautology.
The presence of volatility skew can be intuited from looking
at any plot of the implied volatilities of options in a given
expiration cycle (Figure 1). Visual scans...
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