T2W Trading Community

Volatility Skew Charts
These are charts in which the chart of "historical" volatility is overlaid on the chart of "implied" volatility, enabling you to visually compare them. This is another standard feature available on good broker sites. See figure below (courtesy of BrokersXpress.com)

The chart above compares the historical volatility (red line) with the implied volatility (blue line). The historical volatility looks to be about 90 and the implied volatility is 71.92. So, currently, RMBS is tamer than it has been historically, but not by a lot. However, look at the distance between the blue and red lines after about the first week of April. They're at opposite extremes. The implied volatility was very high and the option premiums were correspondingly high – the perfect environment to sell premium. And, as is usually the case, the uncharacteristically high implied volatility returns to more normal historical levels.

If the implied volatility is currently higher than the historical volatility, the option is overpriced. If the implied volatility is currently below the historical volatility, the option may be a bargain.

This bit of violence (or non-violence) can have a significant effect on an option's price. This is an important concept, but doesn't come into play in all strategies. It's good to know, but it's only one part of many in the decision making process.