The difference in implied volatility (IV) between out-of-the-money, at-the-money and in-the-money options. Volatility skew, which is affected by sentiment and the supply/demand relationship, provides information on whether fund managers prefer to write calls or puts.Also known as "vertical skew". A situation where at-the-money options have lower IVs than out-of-the-money options is sometimes referred to as a volatility "smile", due to the shape it creates on a chart (as above). In markets such as the equity markets, a skew occurs because money managers usually prefer to write calls over puts.
A method of quoting option contracts whereby bids and asks are quoted according to their implied volatilities rather than prices. Used mainly by sophisticated investors, volatility quotes benefit those investors who trade upon volatility rather than price. These investors are typically interested in the likelihood of a contract moving up or down in price rather than in its actual cost.
Trading strategies that attempt to exploit differences between the forecasted future volatility of an asset and the implied volatility of options based on that asset. Because options pricing is determined by the volatility of the underlying asset, if the forecasted and implied volatilities differ, there will be a discrepancy between the expected price of the option and its actual market price. A volatility arbitrage strategy is generally implemented through a delta neutral portfolio consisting of an option and its underlying asset. A long position in an option combined with a short position in the underlying asset is equivalent to a long volatility position. This strategy will be profitable if the realized volatility on the underlying asset eventually proves to be higher than the implied volatility on the option when the trade was initiated. Conversely, a short position in an option combined with a long position in the underlying asset is equivalent to a short volatility position, which will be profitable if the realized volatility on the underlying asset is ultimately lower than the option's implied volatility.
A type of non-equity option that uses the CBOE Volatility Index as the underlying asset. This is the first exchange-traded option that gives individual investors the ability to trade market volatility. Trading VIX options can be a useful tool for investors wanting to hedge their portfolios against sudden market declines, as well as to speculate on future moves in volatility. A trader who believes that market volatility will increase now has the ability to profit on this outlook by purchasing VIX call options. Sharp increases in volatility generally coincide with a falling market, so this type of option can be used as a natural hedge rather than using index options. For advanced option traders, it is possible to incorporate many different advanced strategies - such as bull call spreads, butterfly spreads, etc. - by using VIX options.
The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge". There are three variations of volatility indexes: the VIX tracks the S&P 500, the VXN tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average. The first VIX, introduced by the CBOE in 1993, was a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors' expectations on future market volatility. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.
An agreement between a company and its shareholders whereby the company issues warrants equal to some percentage of the dollar amount of the shareholder's investment. For example, if an investor purchases 1,000,000 shares of stock at a price of $5 per share (a $5,000,000 investment), and the company grants 20% warrant coverage, the company issues to the investor $1,000,000 in warrants or, in technical terms, warrants 200,000 additional shares at an exercise price of $5 per share. This would not give the investor any additional downside protection as the underlying shares would be issued at the same price that is currently paid for the stock. However, the warrant coverage would give the investor additional upside in the event that the company goes public or is sold at a price above $5 per share.
The rate at which the vega of an option will react to volatility in the underlying market. It is the second order derivative of the option value with respect to volatility. It demonstrates the convexity of vega. A positive value for vomma indicates that a percentage point increase in volatility will result in an increased option value, known as positive vega convexity. Vomma is part of the group of measures known as the "Greeks" (other measures include delta, gamma and vega) which are used in options pricing. Vomma is considered one of the more important option pricing Greeks, especially for options that are sensitive to changes in the underlying market. Investors with long options should look for a high, positive value for vomma, while investors with short options should look for a negative one. It is also useful in a delta hedging strategy under traditional methods, but is less useful in dynamic delta hedging. Vomma calculations form an integral part of the Black-Scholes model.
The last hour of stock trading between 3pm (when the bond market closes) and 4pm EST. Witching hour is typically controlled by large professional traders, program traders and large institutional traders, and can be characterized by higher-than-average volatility. The witching hour is most commonly known in the context of triple witching, which is the third Friday of every quarter, when stock index options, stock options and stock index futures expire and roll to the next series. The last hour of these Fridays can be very volatile as positions are adjusted or closed out in anticipation of expiration. Since single stock index options now expire on the same day, triple witching and quadruple witching are used somewhat interchangeably.
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