Volatility Skew

'Volatility skew' is one of those topics that many traders ignore.  It's not something that was understood in the early days (1973 +), when options began trading on an exchange.

According to Wikipedia (quoting John C Hull): "equity options traded in American markets did not show a volatility smile before the crash of 1987, but began showing one afterward."

A volatility smile is defined as 'a long-observed pattern in which ATM options tend to have lower IV (implied volatility) than in- or out-of-the-money options. The pattern displays different characteristics for different markets and results from the probability of extreme moves'

Volatility_smile

image courtesy of investorglossary.com

 

In other words, black swan events occur more often than predicted by mathematical models, and far OTM options trade with a higher implied volatility than ATM options. 

In today's world, this volatility smile is so skewed to the downside that the IV of OTM puts is significantly higher than that of ATM options, which in turn have higher IV than OTM calls.  This is considered as rational in light of the 'frequent' market crashes.  Frequent is defined as far more often than any mathematical model would have predicted.

 

Kurtosis is the mathematical term used to recognize that not all tails of the curve are created eual and that market crashes are far more common than market surges.  Thus, PUT IV exceeds call IV.

The early texts could not mention 'volatility skew' and many of us 'grew up' in the options business with no understanding of the importance of volatility skew.  I now shudder to recall that one of my favorite strategies (late 70s and early 80s) was to own ratio spreads in which I would buy one put with a higher delta and sell 2 or 3 times as many puts with a lower delta.  I thought I was capturing theoretical edge by selling puts with a higher implied volatility.  Today, if anyone were to use that ratio strategy, it would not be to capture edge.  It would be more of a bet on where the market is headed next.

Volatility skew is easy to notice.  All one has to do is look at IV data for any option chain.  Nevertheless, the concept has often proven difficult to explain.  Saving me the trouble of attempting to do just that, Tyler Craig at Tyler's Trading recently described volatility skew in a nutshell.  Thanks Tyler.

 

When teaching traders who have not yet discovered the importance of volatility skew, the skew can be used to explain why one specific strategy is more profitable under certain market condition that others.  This is an important topic for future discussion. 

Mark Sebastian at Optionpit.com suggests one good method for following the volatility skew for a specific underlying asset.  It takes a bit of work, but owning a good picture of skew, as it changes over time, is probably worth the small amount of time that it takes to track the data. 

Sebastian also makes the important point that it's not a good idea to constantly trade the same strategy, using the same underlying, month after month (Guilty.  I'm a RUT iron condor trader.)  Instead volatility skew, among other factors, should be considered.  Iron condors work well when skew is steep and less well when skew is flatter.

Obviously this discussion is incomplete, but just knowing that volatility skew exists and that it can help a trader get better results, makes it a topic that we should all want to understand.

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4 Responses to Volatility Skew

  1. TylersTrading 01/03/2011 at 1:32 PM #

    Hi Mark,
    Nice summary of vol skew. I appreciate the mention.

  2. joseph 01/07/2011 at 12:53 AM #

    Hi Mark,
    i’m trying to trade iron condors while keeping the delta near zero in order to collect time value. i tried using vertical spreads to adjust the delta but near expiration the trade is flat or down a bit? any suggestions as to what i’m doing wrong.
    thanks
    Joseph

  3. Mark Wolfinger 01/07/2011 at 8:44 AM #

    Joseph,
    1) Iron condors don’t make money every month. Thus, there is no indication that you are doing anything wrong
    2) Near expiration is the most risky (and rewarding) time for iron condors. Just asking: Are you certain you would rather trade these near-term spreads, rather than those with more time?
    3) Delta neutral is good. But it is not an end in and of itself. Are you adjusting every day? Are you adjusting every time the market moves 1%? If yes, you are getting back to delta neutral too often. That will kill you in commissions as well as by being forced to sell many dips and buy many rallies.
    Pick a point at which you want to get back to delta neutral and adjust there. But don’t be in a hurry to over-trade. Obviously if your out-of-line, non-neutral delta position makes you uncomfortable, then do adjust at that time (or even before you get to that point)
    4) Did you pay too much for the vertical spreads used as adjustments? That is one way to kill profit potential. Remember that when you buy a vertical you are buying back some of the negative gamma, but are losing a portion of that valuable time decay. Perhaps you have too little time decay remaining?
    5) It’s also possible that you are using the wrong vertical spread as an adjustment. Have you considered buying back the spread you are short? Sometimes that’s just the best adjustment.
    I cannot give a single best answer that applies to your situation. Do any of these comments help?
    Regards

  4. Jeff 11/13/2011 at 10:01 PM #

    Thanks for the ref to the Tyler trading explanation, such advanced strategies are tough to understand for a newer trader such as myself. Regards