Forward skew

Implied volatility
The smirk in Figure 1 is also called a forward skew. In the forward skew pattern, the implied volatility at lower strike prices are lower than the implied volatility at higher strikes. This suggests that OTM calls and ITM puts are in greater demand compared to ITM calls and OTM puts.

Figure 1 – Implied volatility ‘smirk’ – forwards skew.


Can you explain why this smirk occurs?

Hint

Take a look at the lesson on ‘The Black Scholes Model and Implied Volatility’.

Answer

This pattern is common for options in the commodities market. This can be explained by taking a look at the demand and supply schedule. When the supply is tight, businesses would rather pay more in order to secure supply. Otherwise they could risk a supply disruption. Think about an agricultural example. In case a long period of frost is incoming, businesses could hedge for a disruption in their crops supply by securing themselves with crops. This drives up the price of the options for the commodities.