The Skew and Butterfly Charts Shown on the Advanced Options Page

## The Skew and Butterfly Charts Shown on the Advanced Options Page

On our Advanced Options, end of day data page we display a Skew chart.

The description says:

Skew (Risk Reversal) for a set of standard terms.
Calculated as a difference between Put and Call IV for
Given data values of 25% and 10% This measures the excess implied volatility, if any for in-the-money (ITM) call and put options using average implied volatilities for options with deltas near .75, in the case of 25% curve and .90 for the 10% curve. Both examples are ITM options unlike the traditional volatility smile comparing ITM implied volatility to out-of-the-money (OTM) implied volatility.

The skew curves display the extent the two sets of in-the-money options are priced with respect to time to expiration. This is useful for those interested in selecting options for long- term strategies using in-the-money options.

In addition, we display a Butterfly Chart.

The description says:

Butterfly for a set of standard terms. Calculated as an
excess of Put and Call IV for a given delta over doubled
ATM IV for delta values of 25% and 10%

We are using multiple options to compute two approximated hypothetical call butterfly spread curves. Once again, we are using options with delta values of 25% and 10%, meaning that for the 25% curve options we use options with delta values near .75 and .25, while options with delta values near .90 and .10 are used for the 10% curve. Due to the differences in implied volatility between in-the-money (ITM) options and out- of- the-money (OTM) options, referred to as volatility smile, ITM options are more expensive in implied volatility terms and the further ITM the more expensive.

Since a hypothetical butterfly spread using a long call with a .90 delta will be further ITM, it will have higher implied volatility than a butterfly with a long call using a .75 delta option. In addition, there should more excess implied volatility in the spread and this is what is shown on the small graph, as the 10% curve shown in green is higher than the 25% blue curve.

These are hypothetical curves and do not represent actual trades since options that are deep ITM may not be actively traded and the bid/offer spreads may be very wide due to a lack of trading activity. However, for the higher priced stocks with many active option series actual trades may be practical.

Further, butterfly spreads require lower margins and since the maximum valuation is reached when the underlying is exactly at the price of the two short middle options they may be useful when a specific price objective is being targeted. However, since they have an upper and lower breakeven price the 10% hypothetical trade will have both a wider profit range and a higher potential maximum. These potential differences are reflected in the relationship between the green and blue curves shown above.

October 2011, July 2014