Pricing call and put spreads – do we need to account for implied vol and skew movement?
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When pricing a call or put option spread on Volcube, yes you may need to take account of implied vol AND skew, which may be affecting the two legs separately. In the Learning section of the Volcube application, there is a section under Option Theory on Call Spreads which explains this in detail. If the spread is very tight, it may be more of a simple vega spread than a skew trade; in other words you can’t read much into skew nor factor in skew movements in your pricing of this spread. But if it’s a very wide spread, the spread may have a lot of vega, AND skew might be affecting the legs differently. One way some traders deal with this is to figure out what they think the value is in the market of each leg. Say it’s the 100/109 call spread. You might think, vol is trading higher than your Volcube Pricing Sheet suggests and therefore the 100 calls are worth ‘sheets plus say 5 cents’. But say the call skew is trading low; even though vol is higher (raising the value of the 109s), this may be dampened (or even counteracted completely) by the effect of skew. Maybe the 109s then are trading at sheets. This gives you a value for the call spread of ‘sheets+5′. You could then price around that; unless of course you have a bias in which way you want to trade or you are skewing your price because you think the broker has a bias to trade in one direction! There’s a lot to factor in, but that’s all part of training to trade options.
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