Implied volatility & Skew as an indicator of market direction

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Option volumes are the largest across the world and in most cases, multi-fold of the underlying volumes. Do you think Options are derivatives to Underlying or Underlying are derivatives to Options? In my opinion, both are very closely “both ways” correlated, which means that significant volumes and actions in options also affect the underlying behaviour.

This opens new room for analytics, where analysing options-based indicators can help predict the direction of the underlying. In this article, we shall learn how one of the major components of options—implied volatility (IV)— can be used as a forecasting indicator.

In Indian markets, India VIX is available as a volatility barometer for the Nifty but for other indices or stocks a base could be ATM CE/PE IV.

Relationship between IV and Underlying

In most cases a correlation of over 90 percent implied volatility and underlying are inversely correlated, which means that if underlying goes up, IV comes down or quotes mostly at a lower bound, and if the underlying starts correcting, IV shoots up.

Having said that, we should be aware of an exception where in a “known event” like corporate results, monetary policies, fiscal policies, economic data announcements, etc, irrespective of the underlying, the implied volatility may increase due to the uncertainty.

Let’s now understand how this relationship can be used to forecast the underlying.

Forecasts using shift in IV levels

The first and very commonly used indicator is the actual level of IV. Even though the negative relationship holds, there might be divergences in the short-term data. For instance, recently the Nifty corrected but despite the correction, IV refused to move up, this did indicate that the fall is temporary, a reversal was due and we saw the Nifty reacting to that. Similarly, if the underlying moves up and IV also moves up that could be taken as an indication of a nearby top.

Understanding IV Skew

IV Skew is a chart plot of IV levels of strike prices, which is constructed using Put IV for strikes below the underlying’s price and Call IV for strikes above the underlying price. This chart plot forms a shape of “U” as OTM options will have higher IV compared to ATM.

Forecasts using IV skew

The shape of the IV Skew keeps changing with changing market conditions and can broadly be categorised in four regimes.

1. Flattening IV skew: A flattening of IV skew means that the right and the left wing of the “U” shaped IV skew tends to flatten to become a more horizontal curve. This phenomenon generally means that underlying is comfortably bullish and, in most cases, moving up with a marginal positive drift.

2. Steepening IV skew: This happens when the wings of the “U” shaped IV skew starts looking more like a “V”. It will happen when both Call and Puts writers are nervous in writing options and want an extraordinary compensation to sell options, be it calls or puts.

This can also happen due to excessive demand of OTM calls and puts which means the market expectation is of a big move either way. A regime like this generally invites a trend reversal—if the underlying was correcting, it may rebound upwards or if it's moving up, it may witness correction.

3. Left steepening of IV skew: Left steepening means that IV of OTM Puts is increasing at a faster pace. This happens when there is a very high demand of OTM Puts for direction or hedging and these trades are mostly right.

The increase in IV can also be because option writers are sceptical of writing puts as they also expect a higher risk of a fall. In either case, the net forecasting outcome is that if the underlying has a high probability of a fall and if the prices haven’t corrected already, there is a significant chance of a fall.

4. Right steepening of IV skew: This is an extremely rare formation because if the market goes up, the IV level itself will start reducing and this will kill the forecasting benefit due to skew. If the right wing is steepening, this could be a result of an expectation of some unforeseen event. Hence, this formation might not be feasible and should be ignored for a trade.

Summary

Options-based indicators can be used to predict the underlying and IV is one of them. Shifts in IV levels and shifts in skew can help generate these forecasts.

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