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Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?

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What they found

The authors proposed that the volatility smile is shaped partly by supply and demand rather than only by expectations of the return distribution. Using S&P 500 index and individual stock options from 1995 to 2000 with data on whether trades were buyer- or seller-initiated, they showed that daily changes in implied volatility are driven by net buying pressure: heavy buying of index puts raises put implied volatility, and the effect reverses the next day as market makers rebalance. For the index, demand for out-of-the-money puts (portfolio insurance) explains the steep skew; for individual stocks, call demand dominates.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

The volatility smile across strikesImplied volatility plotted against strike, dipping near the money and turning up at both ends, more steeply on the downside.Implied volatility32%28%24%20%8090110120Puts below the money cost moreFar calls cost more tooLowest IV near the moneyATM 100Strike price
The volatility smile. Options on the same stock and the same expiry are not priced off one volatility. Strikes near the money carry the lowest implied volatility, and it rises towards both ends — usually faster on the downside, which tilts the smile into a skew.

What you can use

  • Implied volatility is a price, and like any price it moves with order flow; a rush to buy puts raises put IV independent of any change in risk.
  • Market makers with limited capital demand compensation for absorbing one-sided demand, and that is part of what you pay in the skew.
  • Because the flow-driven part of IV reverses over days, selling into a demand spike has a short-term edge.

Caveats

Sample 1995 to 2000; classification of trades as buyer- or seller-initiated is approximate. The next-day reversal is small relative to bid-ask spreads for retail.

Tags: options, implied-volatility, order-flow, skew

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.