What is option skew trading?

By , CEO of Volcube.

One of the factors that affects the value of an option contract is the expected volatility of the underlying product over the life of the option. Now for options that are struck on the same underlying product and have the same expiration date, you might expect that the same expected volatility is used in their valuation. However, this is usually not the case. More often than not, the volatility component of an option’s value (the implied volatility) varies from option to option even though the underlying product and expiration date may be shared. Why is this?

The reason is that the supply and demand for options with different strikes but a shared expiration date and shared underlying product, varies. For instance, it could be that there is excessive demand for put options relative to call options because investors are looking to hedge the underlying asset. Now the only way for traders to alter the price of options to reflect this bias in demand is by increasing the implied volatility in those options that exhibit disproportionate demand.┬áLet’s take an example. Consider an at-the-money option on a stock that has a 3 month realized volatility of 20% (annualised). Suppose further that the at-the-money 3 month options imply an expected volatility level of 20% during the life of these options. Now we might see that a put with a strike say 10% below the current spot price has an implied volatility level of 25% and a call 10% above has an implied volatility level of 17%. In such cases, we say that the implied volatility curve for this expiration exhibits a put option skew. Other skew types are possible; the call options could be trading at a premium to put options and this might be termed a positive call skew. Both calls and puts may trade at a premium to the at-the-money options (in implied volatility terms) and this may be termed a smile.

So what is option skew trading? Trading skew means to look to trade the shape of this implied volatility curve. It could be that a trader thinks the put implied volatility of 25% is too high relative to the call implied volatility of 17%. In this case, he could sell the puts and buy the calls (all delta-hedged) in the expectation that the skew will move in his favour. Note that this trade (a combo or risk-reversal, as it is known), could be vega-neutral. In other words, the trader is not aiming to profit from movement in the overall level in implied volatility; he may be indifferent to this. All he expects is that the calls will rise in implied volatility terms relative to the puts.

About Volcube

Volcube is an options education technology company, used by option traders around the world to practise and learn option trading techniques.

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