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I´m currently writing a project on volatility trading and dynamics. The literature often states higher demand for OTM (out-of-the-money) and ITM (in-the-money) compared to ATM (at-the-money) options as an explanation for the volatility smile.
I understand why this can explain the volatility smile. The problem is, that I can't see why the demand should be higher for OTM or ITM options than ATM.
Any help to elaborate on this would be greatly appreciated.
Either you or some reference you are following is in error here. At-the-money (or at least near-the-money) options are the most liquidly traded. And trading is much more heavy in out-of-the-money than in-the-money options.
@q.t.f. 's answer is 100% correct. As an OMM, I wanted to add some reasoning behind this.
The practice of trading ATM options has been established for over a century now, and before formal mathematical methods were developed, traders have developed many heuristics for pricing ( proportional to vol ) and hedging ( delta = 1/2 ) .
Typically in a newly listed markets ATM options are the first to achieve liquidity in terms of volume and tightness of spreads. This is probably because this is the most efficient way to get gamma/vega exposure with lowest (%) bid-ask spread.
Quoting OTM options in size requires more skill - market-makers are also more comfortable quoting juicier and more manageble ATMs than a bunch of OTMs that make gamma pop at a specific price level.
Finally there is a technical reason why ITMs rarely trade - they have large deltas, and MMs typically quote them very wide to prevent being picked off by a faster trader when underlying makes a sharp move.
To answer your question, I will directly quote from the book "Option Volatility & Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg:
In total points, a change in volatility will have a greater effect on an at-the-money option than on an equivalent in-the-money or out-of-the-money option.
In percent terms, a change in volatility will have a greater effect on an out-of-the-money option than on an equivalent in-the-money or at-the-money option.
No matter how one measures change, in-the-money options tend to be the least sensitive to changes in volatility. As an option moves deeply into the money, it becomes more sensitive to changes in the underlying price and less sensitive to changes in volatility. Because it is often volatility characteristics that investors and traders are looking for when they go into an options market, it should not come as a surprise that most of the trading volume in option markets is concentrated in at-the-money and out-of-the-money options, the options that are most sensitive to changes in volatility.
