ATM IV Term Structure refers to the relationship between the at-the-money (ATM) implied volatility (IV) of an option and the time to expiration (tenor) of that option. It essentially shows how the implied volatility of an option changes as the expiration date increases or decreases.
The ATM IV is the implied volatility of options where the strike price is closest to the current price of the underlying asset. Implied volatility represents the market’s expectation of future price fluctuations.
Characteristics of ATM IV Term Structure
1. Shape:
• The term structure of implied volatility can take various shapes depending on market conditions:
• Upward sloping (normal): Longer-dated options typically have higher implied volatility because of the uncertainty over a longer time horizon.
• Flat: Indicates little difference in market expectations between short-term and long-term price movements.
• Downward sloping (inverted): Short-term uncertainty (e.g., due to earnings reports or economic events) drives higher implied volatility in short-term options.
2. Drivers of Term Structure:
• Market Events: Anticipated events (e.g., earnings announcements, central bank decisions) can increase short-term IV due to uncertainty.
• Supply and Demand: Heavy trading activity in specific tenors can influence the shape of the term structure.
• Time Decay: The sensitivity of an option’s value to time decay (theta) is higher in shorter tenors, influencing its pricing and IV.
• Mean Reversion: Long-term IV may reflect the market’s belief that volatility will eventually revert to a historical average.
3. Applications:
• Volatility Trading: Traders can exploit differences in IV across tenors to implement strategies such as calendar spreads or diagonal spreads.
• Risk Management: Understanding the term structure helps in pricing and hedging long-term vs. short-term risks.
• Forecasting: Examining changes in the term structure can provide insights into market sentiment and future volatility.
Example:
If a stock is trading at $100 and ATM IV for the 1-month, 3-month, and 6-month options are:
• 1-month ATM IV: 20%
• 3-month ATM IV: 18%
• 6-month ATM IV: 16%
This implies a downward-sloping term structure, where short-term options are more volatile than longer-term ones, possibly due to an upcoming event.
By analyzing the ATM IV term structure, traders and investors can gain a better understanding of how market participants view future price uncertainty across different time horizons.