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Options Theory: Volatility Skew & Iron Condors

April 14, 2022

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Last night I hosted the April Cash Flow Condors Mastermind Meeting. As usual, we teed up the next month’s trade (June, in this case). With IWM near $201, here is the range we were able to get:

June 160/165 bull put & 225/230 bear call for a net credit of 60 cents.

Iron Condor TOS order

The premium received on each side was essentially 30 cents. The short option deltas were also identical at 0.08. From a delta and premium perspective, the condor was perfectly balanced.

And yet, we were able to go 35 points out-of-the-money on the short put but only 24 points out-of-the-money on the short call. Why was it not possible to get equal distance on both sides?

Volatility skew is the answer.

June was not abnormal. Every single month looks like this one. We’re always able to go further OTM on the put side.

What is Volatility Skew?

Recall that each option strike has its own implied volatility. The number varies depending on how much demand there is for the option. Options contracts that are in higher demand are more expensive and thus trade with a higher IV.

The pattern of which options are in the greatest demand isn’t random. It’s a function of investor behavior. One way to think of options is as insurance. If you want to protect against a market decline you buy puts. If you want to protect against a market increase you buy calls.

But wait! Who would want to protect against the market going up?

Bears, or short sellers.

And there aren’t very many of them. Their ranks pale in comparison to the legions that are long stocks and want to protect against crashes. Thus, there’s way more demand for OTM puts than OTM calls. Thus, OTM puts trade with a far higher IV than OTM calls. It’s a phenomenon we refer to as “volatility skew” or “vol skew” for short.

IWM Option Chain
$10 OTM call IV: 21.9%. $10 OTM put IV: 27.9%

This is why when you build an Iron Condor, the market lets you go further OTM on the bull put side while still capturing the same credit as the call side.

This is a Good Thing

Since stocks usually fall faster than they rise, it’s actually a good thing that we’re able to get so much more room on the put side. We’re better prepared for the occasional downside shock. That said, it is one reason why it’s more common to get stopped out of the bear call side of your condor.

Bottom line: don’t get thrown off by the fact that your bear calls are closer than bull puts. It’s a feature, not a bug.

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