SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

What Is Volatility Skew


'Volatility skew' is one of those topics that many traders ignore.  It's not something that was understood in the early days (1973 +), when options began trading on an exchange. According to Wikipedia: "equity options traded in American markets did not show a volatility smile before the crash of 1987, but began showing one afterward."

A volatility smile is defined as 'a long-observed pattern in which ATM options tend to have lower IV (implied volatility) than in- or out-of-the-money options. The pattern displays different characteristics for different markets and results from the probability of extreme moves'

Volatility_smile

image courtesy of investorglossary.com

 

In other words, black swan events occur more often than predicted by mathematical models, and far OTM options trade with a higher implied volatility than ATM options. 

In today's world, this volatility smile is so skewed to the downside that the IV of OTM puts is significantly higher than that of ATM options, which in turn have higher IV than OTM calls.  This is considered as rational in light of the 'frequent' market crashes.  Frequent is defined as far more often than any mathematical model would have predicted.

 

Kurtosis is the mathematical term used to recognize that not all tails of the curve are created eual and that market crashes are far more common than market surges.  Thus, PUT IV exceeds call IV.


The early texts could not mention 'volatility skew' and many of us 'grew up' in the options business with no understanding of the importance of volatility skew.  I now shudder to recall that one of my favorite strategies (late 70s and early 80s) was to own ratio spreads in which I would buy one put with a higher delta and sell 2 or 3 times as many puts with a lower delta.  I thought I was capturing theoretical edge by selling puts with a higher implied volatility.  Today, if anyone were to use that ratio strategy, it would not be to capture edge.  It would be more of a bet on where the market is headed next.


Volatility skew is easy to notice.  All one has to do is look at IV data for any option chain.  Nevertheless, the concept has often proven difficult to explain.  

 

When teaching traders who have not yet discovered the importance of volatility skew, the skew can be used to explain why one specific strategy is more profitable under certain market condition that others.  This is an important topic for future discussion. 


Mark Sebastian at Optionpit.com suggests one good method for following the volatility skew for a specific underlying asset.  It takes a bit of work, but owning a good picture of skew, as it changes over time, is probably worth the small amount of time that it takes to track the data. 
 

Quote

 

How does one find volatility skew?

Is this accomplished by studying the matrix with implied volatility and comparing daily I.V.? By finding richer condors?

Every stock has volatility skew. Some will be steeper than others. The best way to track skew is by looking at the volatility of several options with a specific delta. You keep track of the skew by charting the changes in the volatility of these specific delta options and the spreads between them.

For instance, one might want to keep track of the 5 delta put, the 20 delta put, the 50 delta call, the 25 delta call, and the 10 delta call. Why these options? I think using these options can give a fairly accurate representation of the skew curve. After picking your options, keep track of the volatility, but more importantly, the volatility spreads from strike to strike and option to option. Put them into excel, and fill it in every day. Run a graph over the vols and you will really be able to see the skew curve. Run a second graph over the differences in the vol spread, and you will really be able to see how the curve is moving.

Generally, when we get to about 15 days to expiration, I like to switch to the next month out. Here’s a nice reminder to switch, when you hit the first of the month, you should no longer be using that month to chart skew. In your charts, make sure to note when you switch months. You will actually begin to notice patterns in how the skew curve moves.

As far as condors, those are a good indicator that something is happening, and maybe a very quick short cut. However, it’s not a wonderful way to really track skew.

 


Sebastian also makes the important point that it's not a good idea to constantly trade the same strategy, using the same underlying, month after month (Guilty.  I'm a RUT iron condor trader.)  Instead volatility skew, among other factors, should be considered.  Iron condors work well when skew is steep and less well when skew is flatter.


Obviously this discussion is incomplete, but just knowing that volatility skew exists and that it can help a trader get better results, makes it a topic that we should all want to understand.

Visit our Options Trading Education Center for more educational articles about options trading. 
 

Related Articles:

Start Your Free Trial

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Revisiting Anchor Part 2

    Last month we posted some updates to the Anchor strategy that were obtained using an in-depth back testing of the strategy and variations of it using the ORATS Wheel software.  We adopted three conclusions last month:

    By cwelsh,

    • 0 comments
    • 53 views
  • Covered Calls –Does Rolling Forward Mean Higher Risk?

    Do you roll forward to avoid exercise? It seems like an obviously advantageous move. You avoid exercise and generate a net credit. What can go wrong? Actually, rolling incurs more risk, and every covered call writer needs to study the potential roll and compare the advantages of rolling versus closing and taking a loss or allowing exercise.

    By Michael C. Thomsett,

    • 0 comments
    • 325 views
  • Portfolio Protection Utilizing Calendar Spreads

    Calendar Spreads (including diagonals and ratios) can be a very effective method to “hedge” a portfolio. However, it is not without some complexities.Understanding the Theory and Methodology is important to achieve one’s intended result. In essence, one must understand the whys as well as the hows or they will continuously be faced trying to resolve dilemmas along the way.

    By Reel Ken,

    • 1 comment
    • 611 views
  • The Magic of Compounding, and the Tyranny of Taxes

    Today I want to talk about something that is often ignored, yet has a very large impact on the net performance of our trading and investing: Taxes. To illustrate the importance, I often like to point out both the power of compounding and the impact of taxes with a simple example.  

    By Jesse,

    • 0 comments
    • 185 views
  • How To Select The Best Options Broker

    Selecting the right broker is one of the most important things for options traders. It becomes even more important if you are an active trader and trade hundreds or thousands contracts every month. Select the wrong broker - and your chances to make money are going down dramatically.

    By Kim,

    • 4 comments
    • 631 views
  • Are Binary Options Smart Trades?

    Some ideas are simple at first glance but contain risks that might  not be entirely obvious. Binary options are an example. Some traders love them, just as some roulette players are attracted to the appeal of “red or black” as a 50/50 proposition(or close to it, a 47.4% chance of winning due to the ‘0’ and ‘00’ possibilities).

    By Michael C. Thomsett,

    • 0 comments
    • 419 views
  • Options Trading Matrix

    One of the greatest benefits to trading options is that you can make money in an up, down, or sideways market. For example: In a bull market you can buy calls, or purchase bull call spreads and bull risk reversals. In a bear market you can profit buying puts, bear put spreads and selling bear call spreads.

    By Jacob Mintz,

    • 0 comments
    • 536 views
  • Trading Earnings: The Myths and The Reality

    Nothing impacts stocks prices more than company earnings reports. There are many way to trade those earnings announcements. You can take a directional bet if you believe the stock will move (higher or lower). Or you can play it with some of the non directional strategies.

    By Kim,

    • 0 comments
    • 633 views
  • Delta Hedging Your Options Strategies

    All traders begin with an introduction to call and put options.  However, it's rare (apart from short puts) that an experienced trader would use these contracts by themselves. Instead, we primarily trade options spreads. There are many benefits to spreads. The variety of spreads are targeted to various market criteria and market environments.

    By Drew Hilleshiem,

    • 2 comments
    • 748 views
  • Allocating on Blind Faith

    Almost all passive investment strategies are based on the assumption that younger investors should hold more equities as a percentage of their total portfolio. Likewise, as they age and get closer to retirement, the allocation to fixed income assets should grow while equity holdings shrink.

    By Michael Lebowitz,

    • 0 comments
    • 603 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoticons maximum are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs