The Volatility Multiverse

Why isn’t implied volatility just a single number? In this episode, Mat Cashman breaks down skew, term structure, and the volatility surface to explain how options markets price risk across strikes and time.

Summary – IBKR Podcasts Ep. 381

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Everyone, this is Jeff Praissman with Interactive Brokers, and it’s my pleasure to welcome back to the IBKR Podcast Studio Mat Cashman from the OCC. Hey, Mat. How are you? 

Mat Cashman

I’m great. It’s good to be here, Jeff. 

Jeff Praissman

I love having you come in the studio, and today we’re gonna talk about implied volatility. You know, it’s something that gets quoted all the time, right? Usually by a single number. But you’re here to kind of give us the in-depth details, right? 

Mat Cashman

Yeah. I don’t want people to stop thinking about it as a single number. I don’t think that’s necessarily wrong. I just think it’s somewhat incomplete. When you reduce implied volatility to a single number, you’re basically just taking out something that’s essentially three-dimensional and flattening it into one point. You lose a lot of the information in the process, and really what you’re looking at in total is a surface. But the easiest way to get there is to build up to it. 

Jeff Praissman

Right. And I actually just wanna clarify for listeners: when I say single number, I don’t mean like one through nine. I actually mean like 20%, 30%, 40%, 60%, or whatever. So I just kinda realized, as I was saying it, it might be misconstrued. 

Mat Cashman

When I talk about it in terms of that number, I like to really frame it now as thinking about it in terms of a larger surface. And, you know, in order to really think about the full surface, you need to build up to it in a specific way. 

Jeff Praissman

Mat, what do you mean by build up to it? 

Mat Cashman

Well, I think you have to start where everyone starts, with the number that, like you mentioned, right? Not zero through nine, but when you pull up an option chain, you will see something that says it’s, you know, for instance, a 25 implied volatility. For that option specifically, that’s the option price that you’re looking at and the commensurate volatility number that’s associated with it, and that kind of becomes your anchor point or your reference point for that. 

But on its own, that number doesn’t tell you a whole lot. It’s just a single point with not a ton of context. So the first step isn’t to throw the number out. It’s to ask more broadly, like, what surrounds that number? 

Jeff Praissman

All right, Mat. So let’s peel the layers off then. As we’re digging into this, what’s the next layer of context? 

Mat Cashman

So the next layer above that is to look at where it sits within the month of all the other options that it’s sitting in, where that number sits across the strikes in that month, and that’s what we call skew. So now, instead of just looking at the price of the option and the implied volatility, you’re asking a different question. Not just what is volatility, but more like, where am I on the map of the volatility in this month’s options? And so you have to think about if that 25% implied vol number is attached to something like an at-the-money option, or an out-of-the-money put to the downside, or maybe an out-of-the-money call to the upside, because those are three very different places to be on that map, even if all three of those places might have the same implied volatility number. 

So typically, you’ll see higher implied volatilities in the out-of-the-money puts rather than the out-of-the-money calls. That’s kind of how equity and index options are built in the United States equity market. That’s the market essentially assigning more weight to the downside scenario than it’s assigning to the upside scenario. 

We can talk about historically why that exists. It’s basically that equities and indexes tend to crash to the downside and stairstep to the upside. I always talk about it that way. And so that’s why it’s kind of designed that way, and that’s why it shows up in the skew. And so that same 25% number can look completely different depending on where it lives. It might be low relative to the downside puts, or it might be high relative to the upside calls. 

Jeff Praissman

And so your context really matters, right? The number really only starts to mean something to the trader or the investor once they know where it is. In other words, not all 25% implied vols are created equal. 

Mat Cashman

Yes, exactly. And that number isn’t ever wrong, right? I mean, it’s just a number. It’s a number that’s associated with a price. It’s just, I think, a little bit more of an incomplete picture until you know where it sits within the larger frame of reference. 

Jeff Praissman

We’ve talked about strikes and in the money and out of the money and at the money. Let’s kinda keep digging down into these layers, right? So I’m gonna assume the next layer is time? 

Mat Cashman

Yes, the next layer is time. This is kind of that third dimension that we’re adding to this. If you zoom out again, you’re really looking at term structure. And so you’re asking not only where does this point on the skew curve exist within this month, but then where does this point exist within the larger frame of when does this volatility exist? When does the market expect this kind of volatility to exist? And thus, a five-day option and a 90-day option are not just the same thing with more time, right? They’re pricing different expectations of delivered volatility in the future and different durations in the future. And so short-dated vol might be elevated because there’s an event coming. That’s a possible way that things play out, right? Or longer-dated volatility might reflect broader uncertainty if it’s higher in the back of the curve than it is in the front of the curve. So now you’ve added that third dimension. You’re not just asking, where am I across the strikes within this month? You’re also asking, where am I across the duration curve? Where am I in time? And those two things together start to form a much more complete picture of expectations, not only now but going forward in the future. 

Jeff Praissman

Once you put all these pieces together and these inputs together, that’s really the surface that you were talking about in the beginning. 

Mat Cashman

Exactly. You can look at it like a big blanket that’s kind of layered over a bunch of blocks, right? It’s got strikes on one axis, which you’re seeing on that monthly skew. Then it has time on that kind of Z-axis, I guess, going out in time, which creates the third dimension. And implied volatility is the height of those levels. And so you’re looking at a shape. Most of the time, it kind of looks like waves. You’re looking at something that’s not flat. It has slopes. It has curves. Sometimes it has distortions in different places. You might see a steep front end because near-term risk is elevated relative to the way people are thinking about longer-term risk. You might see one part of the skew be tilted because downside protection is more in demand and is priced higher. 

And you also might see pockets where volatility is higher or lower than the surrounding areas around it, and that might be because there are different expectations for that period of time specifically that aren’t necessarily in the options on either side of it. And if you only look at one number, say the at-the-money implied vol, you’re basically standing in one spot and trying to describe the entire landscape by just looking at one point on the map. And you might be standing, like I said, in a relatively calm area, and there’s a lot of tension a few steps away on your left side that you’re not even really seeing. And so building a broader, more accurate picture of the whole landscape is just a better way to think about it. 

Jeff Praissman

Yeah, and I really liked how you used that wave and blanket description for the chart. It really does look like that. 

With all this being said, why is it important for traders to think about it that way versus, like, that single number, right? 

Mat Cashman

Yeah, it’s important for traders to think about it this way because the options are priced off of the surface, not just off of a single number. So oftentimes when I talk about this, people ask me that question a lot, like, “Why do I care about this?” And the answer inevitably becomes: you don’t necessarily have to care about it if you don’t really want to, right? 

I mean, you could trade something and pay two for it and sell it for three if you want, and never ever think about or look at the implied volatility, and there are people who do that. But I think it’s important to think about it because the people who are making the prices, the people who you’re essentially trading against, I can guarantee you that they’re thinking about this and that they’re very aware of where these prices are and how all of those points on the entire surface are lined up against each other. And the prices, like I said, are coming off of the surface. They’re not a single number. Two options on the same underlying can have very different implied volatilities depending on where they sit on the strikes and where they sit in time on the duration curve. And so when people say volatility is high or volatility is low, the natural follow-up to that should be, “Well, relative to what or where?” Right? I mean, we have to think about it in relative terms. Which expiration is high? Which part of the surface is high? Without that context, you’re missing most of the information that the market is giving you. And guess what? That information is out there, right? You can get that information off of your actual options montage that IBKR gives you, right? 

Jeff Praissman

Yes, absolutely. Yeah, implied volatility is there: bid, ask, center, you know, midpoint. So with all this information that we just discussed as far as implied volatility and skew, how does someone go about thinking about this in actual practice? Like, what are the steps they would take? It’s easy to sit here and kind of describe it, right? Or maybe not so easy. You gotta know what you’re talking about, like you do. But for someone who is maybe newer to option trading or newer to the pricing theories behind options, what’s a really good way for them to walk through these steps and really kinda understand it? 

Mat Cashman

Let’s keep it simple and go through the sequence, I think, is the way to really look at this because inevitably you’re gonna be looking at option price probably to begin with. So then from there, you look at the option that you’re thinking about trading or the structure you’re thinking about trading, look at the actual price of those options, then the implied volatility that’s associated with that price, and then ask, “Okay, where does this strike fit across the other strikes within that month?” That’s number one, right? Find out where you are on the skew. Where is that option that you’re trading? Where does it sit on the skew in that month? And then think about, “Okay, where does that skew sit in time relative to all the other skews out there for all of the different durations?” Because keep in mind, each one of those different tenors, if you’re looking at like a 10-day option versus a 30-day option versus a 60-day option, each one of those option months, those tenors, has their own skew because all of the options within that month have their own implied volatilities. And when you stitch them together, that’s what creates the skew within that month. And then when you stitch that whole thing together, that’s what creates the surface that we’re talking about. 

And so once you’ve done that, you’re not really just looking at a number anymore, right? You’re starting to see a little bit more of the shape, and it gives you a better idea of where you are, not only within the month, but within the term structure of all of the options because implied volatility isn’t just a single forecast, right? It’s a collection of expectations spread out across strikes, which means across price and across time. 

Jeff Praissman

Mat, that was a great summary and a great way for people to think about implied volatility. To take those layers of steps and sort of just dig into it and, instead of it being all-encompassing and maybe a little intimidating, to sort of break it down and make it more friendly for them to kind of work through it and really understand the concept. 

If you could just sum everything up for our listeners, just kind of encompass entirely what we talked about in a few sentences, if you could. 

Mat Cashman

Yeah. It’s very simple, Jeff. It’s very simple. I’ll tie it up in one sentence. I think the best way to think about this is that implied volatility oftentimes gets quoted and gets talked about as just a plain old number because it’s really convenient and easy for us to not only think about it that way, but also talk about it that way with each other. But that number only becomes meaningful, like truly meaningful, once you start to stitch together all of the things that are surrounding it, and that means where it sits within its month and where it sits over time, because that’s really what matters as well. 

Different strikes, different expirations are telling different stories about expectations of movement and where people care versus where they don’t care quite as much. And when you step back and you look at all of it together, you realize you’re not just looking at volatility as a number or a price. You’re looking at how the market is distributing risk across future expectations. And so that, I think, is just a more well-informed way to think about it, and I think it’s gonna help people understand and be able to look at what their risk is specifically, more within the context of the larger risks that are out there. 

Jeff Praissman

Mat, this has been great. And for our listeners, you can find more from Mat at the OCC.com, as well as their, I guess, what would you call it, sister company, brother company, OIC. 

Mat Cashman

Yeah. 

Jeff Praissman

As well as on our website, ibkr.com. Click on Education. Mat has contributed a ton of great webinars, podcasts, articles. He’s a great source of knowledge for anyone interested in trading options. Mat, thanks again. Love having you in the studio. 

Mat Cashman

Absolutely. Thanks for having me. 

Jeff Praissman

Great.