What is the Volatility Skew, and How Can You Trade It?

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Volatility Skew: what is it?

Option skew, another volatility skew, is used in options trading to describe the variance in volatility across at-the-money, in-the-money, and out-of-the-money options. These phrases describe the link between the market price and the contract’s strike price in options trading.

There is a range of implied volatility in options contracts for the same underlying asset with the same expiration date but various strike prices. It is, in other words, a graph plot of implied volatility points that reflect various strike prices or options contract expiry dates.

The volatility skewness is the slope of the implied volatility on that graph, and while each asset class appears differently, they all frequently resemble a smile or a smirk. A “volatility grin” refers to a balanced curve, whereas a “volatility sneer” refers to one lopsided to one side.

Implied Volatility (IV): What is it?

A prediction of the volatility that a certain underlying asset would experience between the present and the expiration date of the corresponding options contract is known as implied volatility, indicated by the sigma symbol (). It essentially refers to investors’ uncertainty over an underlying stock and traders’ perception of the likelihood that the stock will reach a specific price on a specific date. An underlying asset’s volatility is continually fluctuating. The more volatile an asset is, the more its price fluctuates. Implied volatility, however, is not always predictable since it depends on how investors perceive the asset and whether they believe it will experience volatility. Standard deviations and percentages over a predetermined period are frequently used to illustrate implied volatility.

Option pricing assumes that, although having various strike prices, options for the same asset with the same expiration have the same implied volatility. However, investors are ready to overpay for stock options with downside strikes because they believe the downside to be more volatile than the upside.

When choosing their options trading strategy, traders should remember that different types of options contracts have varying degrees of volatility.

What Does Investor Volatility Skew Mean?

Supply and demand, as well as investor perception of the options, all affect volatility. Investors may better comprehend the market and choose whether to purchase or sell certain contracts using the volatility skew. Investors who trade options should pay close attention to this signal.

Generally, stocks that are losing value exhibit greater volatility. An option’s price rises when an underlying entity’s implied volatility is present, creating a downward equity skew.

Prices will increase if implied volatility for skew is bigger. Investors can use volatility skews to identify low- and high-priced contracts to determine whether to purchase or sell a contract.

Volatility skew comes in two flavors. The volatility skew of several strike prices for options contracts with the same expiration date is displayed vertically. Individual traders utilize this more frequently. The volatility skew of the expiry dates of options contracts with the same strike price is displayed horizontally.

How Is Volatility Skew Measured?

Investors display graph points of the implied volatility of strike prices or expiry dates to calculate the volatility skew. For instance, a trader may review a bid list and ask for prices for options contracts for a specific asset that expires on the same day. They plot the midpoint implied volatility points based on the bid and ask prices.

As market sentiment shifts over time, the skew’s tilt also does. Investors can utilize these shifts as extra information about the market’s direction for skew trading by keeping an eye out for these movements. For instance, traders may believe that a stock is overbought if its price rises dramatically, leading them to believe its value will decline. This will alter the skew such that its curve steepens, increasing the pressure to put options in the money or on the downside.

The following five factors influence the price of options:

Five factors influence the price of options:

  • Underlying stock or asset market price
  • Strike price
  • Time to expiry
  • Interest rate
  • Implied volatility

How Can Volatility Skew Be Traded?

As was already explained, the two forms of volatility skew are horizontal and vertical. Both can be applied to trading.

Horizontal Skew

Changes in horizontal skew are influenced by various variables, including product releases, financial reports, and world events. For instance, the implied volatility may rise, and the horizontal skew may flatten if traders are concerned about a stock’s near-term prospects due to an impending earnings release.

Trading opportunities are found by comparing the variations in implied volatility between option expiry dates using calendar spreads. Traders may be able to profit from inefficient pricing if there is implied volatility in a horizontal skew.

Positive horizontal skew refers to the relative price premium the option contract will have if the implied volatility in the front month is higher than anticipated.

On the other side, negative horizontal skew sometimes referred to as “reverse calendar spread,” occurs when the implied volatility of the back month is higher than anticipated. Because traders can benefit if the underlying asset price rises before the back month contract expires, traders would sell the back month and purchase the front month in this scenario.

For instance, a trader may see a horizontal skew in the option calls for a particular stock, which indicates that traders are placing buy and sell orders based on the expectation that the price would grow significantly more probable over the long run than over the short term.

The trader can utilize a reverse calendar call spread comparable to shorting a company and forecasting its decline if they don’t believe the present market projections are accurate. The long-term and short-term contracts will lose value if the stock price falls, and the trader can purchase them back at a lower cost than sold.

In this scenario, if the implied volatility of the options declines, the trader can also profit. They opted to sell during the front month when implied volatility was high so they could purchase back at a lesser price if implied volatility dropped.

The fact that this is a short call and requires a substantial margin makes it dangerous, even if it has the potential to be a winning trading strategy. If a trader wants to make this kind of transaction, the stock exchanges need them to have a sizeable amount of money in their account.

Investment Risks and Management Techniques are advised.

Vertical Skew

Because vertical skew trading is easier than horizontal skew and involves less margin and risk overall, it is preferred by many investors. Vertical skew, also known as volatility skew and options skew, examines variations in the implied volatility of several stock strike prices with the same expiry date. To trade debit spreads and credit spreads, traders can use a vertical skew to identify the optimum strike prices for buying or selling.

For instance, a trader could come upon a stock they think will appreciate before their option contract ends. They thus seek a bull put spread to purchase to profit from price gains. They will have a wide range of strikes to select from, so they may utilize vertical skew to determine which trades—those that are cheap or high-priced—are the best. The trader can pick one with a reasonable price, purchase it, wait for it to grow up in value, and then sell it for a profit.

The Lesson

Many investors like trading options, and volatility skew is one method options traders use to assess the cost of options contracts. To determine if purchasing an options contract makes sense for their investment plan, traders may consider either the horizontal or vertical skew.

Opening an account on the SoFi Invest® brokerage platform is a simple way to get started for investors searching for a more direct method of portfolio construction. You may study, track, purchase, and sell stocks using the investing platform directly from your phone. All of your financial data is conveniently accessible in a single dashboard. The SoFi staff is accessible at any moment to assist you if you need assistance getting started.

Reference:

What is Volatility Skew and How Can You Trade It? | SoFi. https://www.sofi.com/learn/content/volatility-skew-options-trading/

The Greeks: Measuring Risk – Lyra Blog. https://blog.lyra.finance/the-option-greeks/

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