The pattern usually takes one of two forms: The most common place to find a positive skew is in the futures markets, particularly the grains Corn, Wheat, or Soybeans although others such as Coffee, Sugar, and so on normally have a positive skew as well. This particular type of skew is just a fact of life, reflecting the difficulty of making longer-term volatility projections.
The theory behind "trading the skew" is that you are getting a theoretical advantage by essentially buying and selling options on the same entity the underlying , yet these options have different volatility projections for that single underlying. Obviously, those volatilities must eventually converge — one option is, by definition, overpriced with respect to the other. There are some subtleties to this theory, but the general idea is a valid one.
Traders who "trade the skew" generally use a spread — buying the cheaper lower implied volatility options and selling the expensive higher implied volatility ones. Hence bull spreads, bear spreads, ratio spreads, and backspreads are favored strategies. More will be said about them in a minute.
Sometimes, calendar spreaders are attracted by a very distorted horizontal skew, but there are other things that are perhaps more important in that strategy. For those wanting more background and education on volatility skews and how to trade them, I suggest you consider taking our online option seminar on the subject, " Volatility Trading Part 2. For those looking for lists of stocks and futures with skewed options, we publish such data daily on The Strategy Zone.
The following is a small excerpt of how the data looks:. Then the composite implied volatility is shown. The next two numbers are the important ones as far as identifying the volatility skew, if it exists. This is nothing more than the standard deviation of the implied volatilities on this entity.
The number next to it Skew normalizes the number, by dividing it by the composite implied volatility. The larger these numbers, the more skewed the options are. The second number Skew is probability the more important one, since this number can be compared with other stocks, indices, and futures. You will normally see that the list is dominated by futures and index options — as they have the most common skews.
Occasionally some stock options will creep into the top of the list as well. One must first ask questions, such as "How is the skew distributed? That is, are the near-term options trading with a much higher implieds, and thus distorting things? If so, calendar spreads might be your preferred strategy. On the other hand, if the skew is vertical, you will notice the implieds either uniformly getting larger or smaller as you look at the strikes, reading from lowest to highest.
Assuming you find a skew you like, the next paragraph presents the general rules for trading it. Call and put ratio spreads involve naked options, and thus have theoretically large or even unlimited risk.
As such, they are not suitable for all traders. Be sure you know what you're doing before getting into those strategies. Again, if you're at all uncertain about this concept trading the volatility skew or its implementation via the above strategies, do more reading or take the course on the subject.
For volatility skew trading candidates on a daily basis, subscribe to The Daily Strategist. Trading or investing whether on margin or otherwise carries a high level of risk, and may not be suitable for all persons. Leverage can work against you as well as for you. Before deciding to trade or invest you should carefully consider your investment objectives, level of experience, and ability to tolerate risk. The possibility exists that you could sustain a loss of some or all of your initial investment or even more than your initial investment and therefore you should not invest money that you cannot afford to lose.
You should be aware of all the risks associated with trading and investing, and seek advice from an independent financial advisor if you have any doubts. Past performance is not necessarily indicative of future results. Posted in on March 19, - 1: The following is a small excerpt of how the data looks: Using the List You will normally see that the list is dominated by futures and index options — as they have the most common skews. Assuming the skew is vertical, then: If the skew is positive and the composite implied volatility is in a very high percentile, then consider Call ratio spreads as a strategy.
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