When looking at option chains, I often notice that the (broker calculated) implied volatility has an inverse relation to the strike price. This seems true both for calls and puts.
As a current example, I could point at the SPY calls for MAR31'11 : the 117 strike has 19.62% implied volatility, which decreaseses quite steadily until the 139 strike that has just 11.96%. (SPY is now at 128.65)
My intuition would be that volatility is a property of the underlying, and should therefore be roughly the same regardless of strike price.
Is this inverse relation expected behaviour? What forces would cause it, and what does it mean?
Having no idea how my broker calculates implied volatility, could it be the result of them using alternative (wrong?) inputs for calculation parameters like interest rate or dividends?
Answer
The skew is almost always bid for puts on the stock market. When stocks go down, people tend to panic and volatility goes up as a result. Since the puts get more vega when the market goes down, they trade at higher vols. Read up on stochastic volatility for a more in-depth explanation.
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