Volatility Skew. Part II

Using Volatility Skew

Volatility Smile
Volatility Skew: The volatility smile. Google Images

Part 1: An introduction to volatility skew.

Many individual investors use options to enhance their earnings potential. Among those investors are those who prefer to take the easy way through their lives -- and that includes how they handle investing and trading. Nothing wrong with that, but if you take the time to learn more, the chances are good that your performance will improve.

One way that the more sophisticated options trader can take advantage of extra knowledge occurs in situations in which the volatility skew (i.e., the "flatness" or "steepness" of the volatility curve) is changing.

 

  • When the skew curve is relatively steep by historical standards, that represents a good opportunity to initiate trades that will earn a profit -- if and when the curve becomes less steep and regresses toward its average value.

    Steep skew translates into higher prices (due to higher IV) for OTM put options and lower prices for OTM call options. The trader can select a spread that shorts those high-priced put options to gain a theoretical advantage. For example, the ratio spread allows the trader to sell a larger quantity of further OTM options -- at an elevated price -- then he/she buys. NOTE: Selling extra, or naked options may be too risky for you because the potential loss is essentially unlimited.
     
  • When the current skew curve is relatively flat by historical standards, then traders can take advantage of that situation by owning OTM options at less than their usual cost. This strategy works for investors who prefer to own OTM options as portfolio protection, despite the fact that options lose value as time passes. It is also popular among traders who like to own OTM calls -- just in case  of an unexpected market surge.

    The flat curve presents an opportunity for butterfly spread traders because that strategy involves buying the reduced-price OTM options and selling ATM (at-the-money) options.

    The process for evaluating whether the current skew is flat or steep is not difficult, but it does take time to determine whether there is an edge that you can capture. If you plan to take advantage of as many opportunities as possible to gain a theoretical edge when trading options, it is worth your time to understand the basic concepts of options, and that includes volatility skew.

    The ideas mentioned here are similar to those published by Jared Woodard at Condor Options.