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

  • The Real Meaning of the Efficient Market Hypothesis (EMH)

    Most traders have heard of the efficient market hypothesis (EMH) and most believe they know what it means. In a nutshell, it is a belief that the market is “efficient” and that the current price of shares is a reflection of efficiency. Right? Wrong.

    By Michael C. Thomsett,

    • 0 comments
    • 169 views
  • Put Permanent Portfolio

    Harry Browne popularized the concept of the "Permanent Portfolio" decades ago by recommending an asset allocation of 25% stocks, 25% bonds, 25% gold, and 25% cash. In the 90's, the concept of "risk parity" also became popular with writings by Cliff Asness of AQR Capital.

    By Jesse,

    • 0 comments
    • 527 views
  • Does HFT Harm Individual Investors?

    What is the overall impact of High Frequency Trading (HFT)? Some traders believe that the use of algorithms in super-fast and powerful computers allows large hedge funds and other institutions to beat the market, implying that because these big traders can out-perform individuals, profits are unfairly gained. But is it true?

    By Michael C. Thomsett,

    • 0 comments
    • 543 views
  • Defining the Anchor Strategy

    Lorintine Capital and Steady Options have been trading the Anchor strategy for a number of years. During this time Anchor has evolved as we have learned more, in no short part due to the Steady Option’s members continuing questioning of the strategy, insights they provide, and a large group of individuals seeking to improve the strategy’s efficiency. 

    By cwelsh,

    • 0 comments
    • 491 views
  • The Life Of An Options Contract

    You may be asking yourself why am I reading this basic article about options trading? Well, if you’re anything like me, I didn’t learn options trading via the fundamentals.  Rather, I found a few strategies that made sense to me and started trading, without much regard to the underlying workings and details.

    By Drew Hilleshiem,

    • 1 comment
    • 1,438 views
  • Volatility Trends in the DJIA

    Options traders focus, often too much, on implied volatility to estimate the next change in option valuation. Is this always a wise policy? Options are derived from volatility in the underlying security (thus the term derivatives), a good question is: Why not focus on volatility trends in the underlying (historical volatility) to judge likely future valuation trends in options?

    By Michael C. Thomsett,

    • 0 comments
    • 819 views
  • Bitcoin Helps the Financial Market Evolve

    In our Bitcoin: The Greater Fool Theory article, we discussed how the most popular cryptocurrency in the world can be compared to a worrying trend. The ‘greater fool theory’ states that the price of an asset is determined not by its intrinsic value but by the sentiments and expectations of market participants.

    By Kim,

    • 2 comments
    • 494 views
  • Trend Following: An 88 Year look at S&P 500

    Many investors have become interested in trend following strategies in recent years due to the scars of living through two major bear markets since 2000. In my firm, we also believe in trend following as a sustainable method for managing the downside risk of investing in risky assets like equity index funds and ETF's. 

    By Jesse,

    • 0 comments
    • 569 views
  • Leverage With A Poor Man’s Covered Call

    Diversification can be an issue for traders with smaller account sizes. It can be incredible difficult to trade covered calls and create a diversified portfolio. For example, an investor with a $25,000 account would use up over half his capital doing one covered call on AAPL stock.

     

    By GavinMcMaster,

    • 0 comments
    • 1,464 views
  • Are you a Hedger Or a Speculator?

    Many options traders seem to have a problem defining themselves. Repeatedly, we see traders describe themselves as conservative, using options primarily to hedge market risk. But … are they staying true to this definition.

    By Michael C. Thomsett,

    • 0 comments
    • 1,196 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