Understanding Volatility Skew in Options

By MoneyShow.com | February 29, 2012 AAA

Jared Wooodard of CondorOptions.com explains how volatility skew can affect your trading success and profits.

The jargon of options trading sometimes turns people off, and maybe “volatility skew” is one of the biggest hurdles. So I’m going to explain the concept in a straightforward way, and then explain why volatility skew is something you should care very much about.

Here is a video explaining volatility skew:

The Problem with Volatility Skew from Condor Options on Vimeo.

Volatility skew usually refers to the difference between the implied volatilities of options at different strike prices in the same expiration cycle. For the majority of stocks and indexes, options with high strike prices have low implied volatilities, and options with low strike prices have high volatilities.

For example, with SPDR S&P 500 ETF (SPY) trading recently at $136.63, options for April expiration struck at 136 had an implied volatility of 15%. If you look further away from the current price, down to the 125 strike, you’ll see that those options are priced much higher in implied volatility terms— currently, at 21%. That difference between 15% and 21%, roughly speaking, is the volatility skew.

chart

Click to Enlarge

The reason you should care deeply about levels of volatility skew is that it can make or break your portfolio. Here are two ways that paying attention to skew can have a major impact on your profitability.

  1. Skew curves that are historically flat present excellent opportunities to put on portfolio hedges at a fraction of their normal cost. A very popular hedging method among equity investors is an option collar, which involves buying an out of the money put option and selling an out-of-the-money call option against a long stock position.

    Hedging methods like option collars are often applied and rolled based only on the calendar. Instead of, for example, rolling an SPX option collar forward every quarter to keep a stock portfolio protected, investors can use skew data to inform those trades. Applying collars when skew is historically flat or low will reduce costs, since the purchased puts will be cheaper than average and the sold calls will be more expensive than average—again, relative to at the money levels.

    Getting downside protection when it’s cheap and selling upside gains on your stock for a good premium is a great way to boost returns. Additionally, scaling out of collar or put protection as volatility skew becomes steep will maximize gains from those trades.

    Finally, hedgers can compare the volatility skew among several viable hedging candidates to determine which offers the cheapest options.

Conversely, skew curves that are historically steep present opportunities for great speculative trades—bets that the curve will moderate back to average levels. For speculators, skew is valuable because it presents another avenue for profit that can be traded independently of any forecast about future price or even future volatility. I put on just such a trade in the United States Natural Gas Fund (UNG) a few days ago. UNG put skew was quite high, and the ratio trade we entered was constructed to take advantage of those abnormal levels. Additionally, skew data can inform the structure of other conventional volatility-based trades. Imagine that you believe implied volatility in general is too high relative to likely future volatility, such that a net options sale is in order. You could sell an iron condor with strikes placed far out of the money, or you could put the same amount of capital at risk in a butterfly, selling at the money implied volatility and buying nearby protective wings. When skew is high, meaning that out of the money options are richly priced, the condor trade will have a better expected return; conversely, low skew gives you the clearance to trade the butterfly.



The problem, however, is that simple visual displays of skew don’t tell us whether the curve is historically flat or steep. As I mention in the embedded video above (also available here), simply looking at a skew chart won’t indicate whether there is an opportunity for a speculative trade or a chance to hedge your portfolio inexpensively. A little painless math and some historical data make more thorough analysis possible, and I published the results of such a study in the featured article for the February issue of Expiring Monthly.

By Jared Woodard of CondorOptions.com.

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