It is often a daunting task deciphering the tremendous amount of options information contained within an option chain for the trader beginning his study of the world of options. One of the most nuanced variables embedded within the prices quoted for the chains is that of the relative values of implied volatility (IV) amongst the various strike prices and the various months of expiration.
The IV of each of the various available options for a given underlying is not usually constant for each individual strike price and expiration cycle. The IV can and often does vary between individual strike prices within the same cycle; this variation is termed vertical skew. In addition, IV often varies at the same exact strike price when considered between various expiration cycles; this variation is termed a horizontal skew.
To review briefly, remember that option prices depend largely on the three variables: time to expiration, price of the underlying, and IV. The only one of these factors not immediately accessible to anyone with a quote screen and a calendar is IV. It is by changes in the magnitude of IV that future events of potential major import to the price of the underlying are expressed.
As an example of the information that can be gained by considering skewed values for IV is the stock AFFY. This biopharmaceutical stock is represented in upcoming expiration cycles of: April, May, July, October, January 2014 and January 2015. Considering the example of the 3 strike call, the IV for these various months at the time of this writing are: 222, 189, 171,131, 137 and 110 respectively.
The company just announced a significant reduction of their workforce due to an ongoing investigation surrounding one of their product. The options markets are pricing a substantial probability of a significant price move earlier than later. These types of IV spikes are typically seen in biotech stocks ahead of significant FDA decisions or product investigations like in this instance.
The bottom line for an option traders is to make sure they know how the IV might influence their decision making and understanding why there are discrepancies in the first place.
Senior Options Instructor