Skew You. Is volatility skew important?

Hi Mark,

Happy New Year, and thanks again for the blog. When you say IV [in reference to this post on theoretical value of an iron condor], do you
mean IV for the specific strikes, or do you mean IV as per (say) the
VIX/ATM strike? It seems like taking the average IV of your short legs
as a quick rule of thumb might help adjust for skew, or is that not
really a big problem?

Jason,

***

Skew is an issue I have avoided.  Discussions can get complicated and I believe that keeping things simple works for most traders.  And keep in mind that this blog is primarily directed to the option rookie – at least that was my original intention. 

The 'skew' is merely a characteristic of the implied volatility for the options of any given underlying asset.  In general, implied volatility (IV) increases as the strike price get lower.  That's another way to say that IV for puts is greater than IV for calls.  There is no simple formula that can be used as a 'skew rule' because skew is not the same for each stock and is not even constant for a given stock. 

Skew increases as the strike price declines and and a result, farther OTM puts have a higher IV.  Similarly farther OTM calls have a lower IV.

Now to reply:  I am referring to average IV.  Why do I do that and ignore skew?  Because the trades I discuss (IC for example) use adjacent strike prices and the skew is minimal when strikes are near each other. When trading those spreads, I choose to ignore skew.

It's difficult to make a good volatility estimate when determining theoretical values; it's next to impossible to make a good estimate for skew.  As a result,
most traders (as far as I can tell) prefer to work with the current implied volatility, rather than estimating their own. 

As a result  options are considered to be reasonably priced, with obvious exceptions (pre-earnings).  But it also means that most traders who lack sophisticated computers that seek out every penny in edge, don't have any mathematical edge when making a trade.  I'm willing to accept that.  Others are not, and need that edge.

Is it a big problem? Jason, I know I am oversimplifying here, but to me it's not a big problem.  If you see it as a problem, I would not argue.

I know that more sophisticated traders may chuckle at that and I would not blame them.  If they have an edge, good for them.  I don't know how to find that edge.  Years ago, I did seek pennies in edge.  But I was a professional trader working for a trading company.  Today I trade my retirement account – which has considerably less money that my trading account did.   But I also have much less stress, fewer details to worry about, and less edge.

Happy New Year.

572


4 Responses to Skew You. Is volatility skew important?

  1. Steve 01/08/2010 at 4:31 PM #

    Hello Mark, appreciate your advice. As someone new to option trading, I have a fairly basic question. Let’s say I am short naked SPY puts, say 105 strike price, and I shorted/sold them at .20. The puts are going to expire worthless and instead of buying them back, I will get assigned/or get long SPY from 104.80? Is this correct? This would obviously seem too easy to make money. Thanks in advance.

  2. Mark Wolfinger 01/08/2010 at 5:00 PM #

    Steve,
    Basic yes. But very important that you understand how this works.
    And it is not that easy to make money – or the whole world would be doing it.
    If the options expire worthless, you will NOT be assigned an exercise notice, you will not buy SPY shares. You will not pass GO and you will not collect $200.
    If, in a different scenario, you were assigned an exercise notice, you buy the shares at the strike price. You do NOT buy them at the strike price less the premium you collected.
    This may seem to be a trivial distinction, but: Your net cost would be that $104.80 you mentioned. But in fact you buy at the strike. That’s important to the person from whom you would buy the shares. He/she gets $105 – and it does not matter how much premium you collected.
    Please let me know if this is not crystal clear. It’s not difficult. Once you see it, you see it. But sometimes explanations may not be worded carefully enough. I don’t want that to happen here.

  3. Steve 01/09/2010 at 8:07 AM #

    Thanks for the quick response.
    I need to read up on this stuff is my conclusion.
    If the puts expire worthless (ie SPY closes above 105 at Op Ex), I will not necessarily be assigned is what you are saying? I think I understand, but I’ll try…
    And in Scenario 1 , I’m not assigned and I just keep my premium.
    In Scenario 2, I get assigned and get long at 105, what happens to the prem? Let us say I shorted the Jan SPY 105 puts at 5. And Lets say that next week SPY closes (Op/ex) at 110. If I didnt keep the premium, does this make me break even? Do I need a close above 110 to make money in this case? I dont want to make this more complicated, just trying to get a hold on things. I’m obviously into a situation I do not know enough about (luckily its not a losing trade). Thanks again,
    Steve

  4. Mark Wolfinger 01/09/2010 at 12:52 PM #

    Reply in a separate post