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"Ever heard of the skew effect\?"

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"Ever heard of the skew effect?"
By Lee Lowell

Ok, now that we've got a handle on the different types of volatilities and how to figure them out, let's see how we can use it to our advantage in the marketplace. As I was talking about my last article with my father; he said to me, "explain how this volatility thing works with an example". Here's what I showed him: (hypothetical example)

March 1, 2000			March 1, 2000
IBM stock $100/share		YHOO stock  $100/share
IBM June  $100 call = $5	YHOO June  $100 call = $10

Why is YHOO's June $100 call double the price of IBM's $100 call? They both have the same stock price, the same strike price, and the same expiration date. (we'll leave out interest rates and dividends since they don't have a major effect). There is only one explanation for the difference in option premiums, and that is VOLATILITY! YHOO is a much more volatile stock than IBM and it is reflected in its option premium. YHOO can blast through so many different strikes on any given day and then reverse itself back down too. IBM takes the nice slow path of going through strikes (if it moves at all). Since YHOO has the ability to turn out-of-the-money options into in-the-money options more quickly, its volatility component will be much higher. This is the effect volatility has on option premiums.

Let's move onto something deeper. Have you ever heard about volatility "skews"? This is one characteristic of volatility that makes for great trading opportunities. In a perfect market, all the implied volatilities of each strike in an option chain would be trading at the same level. For example, XYZ corp. is trading at $65 and has option strikes ranging from $50 - $100. Each option (puts and calls) has an implied volatility of 35%. This is what's called a flat skew. Most stable stocks can have this sort of flat skew. Now, very volatile stocks can have what's called a sloping skew. This is when the implied volatilities for each strike are different. ABC corp. has strikes ranging from $25 - $200 because it has moved within that range over the last 3 months. It is trading at $80 today and its implied volatility for each strike looks like this: 75%, 77%, 80%, 82%, 85%, 88%, etc. etc. starting with the at-the-money call strike and moving higher. The same can be said for the puts. Starting with the at-the-money put and moving lower in strikes.

Here's what the levels would look like for XYZ corp.:

Calls Strike 80  85   90   95  100  105 
Imp. Vol.    75% 77%  80%  82%  85%  88%	

PutsStrike  55  60  65  70  75  80
Imp. Vol.   88% 85% 82% 80% 77% 75%

You can see as the calls increase from the at-the-money strike, so does the implied volatility. And as the puts decrease from the at-the-money strike, the volatility goes up. The out-of-the-money strikes have the higher implied vols. This is called a "smiling skew" because if you plotted the levels on a graph, it would look like a smile. What is the reason for this? Good question. It is mostly because of the uninformed amateur option players out there that make up most of the general public. And due to lots of speculation. Many traders like to play the out-of-the-money options because they are cheap and the rewards can be huge if the stock moves in their favor. As the volume increases in the out-of-the-money options as more people want to get in on the move, there is pressure to bid up the option premiums and the market makers are aware of this. So they keep bumping up their asking prices. This is turn leads to higher implied volatilites on these options. This holds true for calls and puts. One of the reasons why the puts have this sort of skew dates back to the crash of '87. Many people got burned on the downside so lower strike puts will usually have higher implied volatilites now. This is really evident in the S&P 500 put options. If you are using a real-time data feed that gives implied volatility levels for an option chain, look for the skew effect.

Not all skews are smiling though. Some options have downward sloping skews in the calls as the strikes increase. This is due in part by many large hedge funds and institutional firms that employ covered call writing. These funds are long the underlying and short the calls against them. As many more firms employ this strategy and sell the calls in volume, this tends to bring down the call premiums, thus lowering its implied volatility. At the same time as the call are sold, these same firms may be buying the downside puts for protection too. (thanks to the '87 crash effect) This tends to raise the implied vols of the out-of-the-money puts as I said before. So the volatility "skew" can have a few different shapes. Just look at different option chains that supply implied volatility numbers and you can see this effect.

So how do we use the skew effect to our advantage? It can be employed in a few different spread type strategies. Let's start with options that have a smiling skew. If you are bullish or bearish on a stock but want to be conservative in your option strategy, then you can initiate debit call and put spreads to lower your overall cash outlay. If you buy a call spread on options with a smiling skew, you are assured to buy the option with the lower implied volatility and sell the option with higher implied volatility. For a put spread, you'll be buying the put that has a lower implied vol. and selling the put with higher implied vol. So what does that mean? This automatically puts the odds in your favor. Or should I say, starts you off with an advantage. All options on the same underlying stock should trade at the same volatility, but they don't. Why would someone pay more (on an implied volatility basis) for an option in the same chain on the same underlying? I told you before. It's because of speculators who want to get in on the game and buy cheap out-of-the-money options. This buying pressure causes the implied volatilites of the further out-of-the-money option to slope higher.

So when you buy an option with lower implied volatility than the option you're selling, you already have the odds tipped in your favor. Now whether or not you eventually make money on your spread will be determined by where the underlying stock ends up. But at least you know that you started with a slight advantage. Let's look at an example to help clarify my ranting.

XYZ corp. at $50 with flat skew:

Calls     50  55  60  65  70  75  80

Imp. Vol. 35% 35% 35% 35% 35% 35% 35%

Premium   5    4   3   2   1  .5  .25

XYZ  $60 - $75 call spread = $2.50

XYZ corp. at $50 with smile skew:

Calls     50  55  60  65  70  75  80

Imp. Vol. 35% 37% 39% 41% 44% 47% 50%

Premium    5  4.5  4 3.75 3.5 3.25 3

XYZ  $60 - $75 call spread = $.75

Do you see what happened here? If you bought the XYZ June $60 - $75 call spread with a flat skew, the spread would cost you $2.50. But with the smile skew, the same call spread would only cost you $.75. That's a big difference! That's a $1.75 cheaper per spread. This is what volatility analysis can do for your trading. It can start you off with an advantage. I highly recommend checking the implied volatilites for the strikes you're interested in trading.

Now let's use a different kind of spread to take advantage of the skew effect. We'll use the ratio spread this time. A ratio spread consists of buying a closer-to-the-money option and selling two or more further out-of-the-money options. The ratio could be 1:2 or 1:3, depending on your outlook and risk tolerance. Most of the time you would want to initiate a ratio spread for a credit or $0 net into your account.

Here's an example using the same XYZ data:

If you were to put on the XYZ $60 - $70 1x3 call spread with the flat skew, the cost would be $0 plus commissions. Your position would consist of long 1 XYZ $60 call at $3 and short 3 XYZ $70 calls at $1, for $0 net. (for the short side, just multiply the number of contracts by the premium. 3x $1 = $3. So your total long premium minus the short premium = $0)

If you were to put on a ratio spread using the smile skew, with a ratio of 1x2, here's what the outcome would be. You would be long 1 XYZ $60 call at $4 and short 2 XYZ $70 calls at $3.50 with a net CREDIT of $3 in your account. Now that's nice! And the good part is that your ratio has been reduced to a 1x2 contract spread vs. the 1x3 contract spread with the flat skew example. This smaller ratio reduces your outright risk if the trade should happen to go against you.

Let me just expand on why someone might want to do ratio spreads and how the final numbers might look. XYZ corp. is $50 today. A trader might believe that XYZ will not go any higher than $70 per share over the next 3 months. So he/she will put on a ratio spread of long 1 $60 call and short 2 $70 calls for a credit of $3 (using the example above). At expiration day, XYZ closes at $68. Here's what happens:

Long 1 $60 call in-the-money = $8, for a total gain of $4.
($8 - $4 initial outlay = $4 gain)
Short 2 $70 calls out-of-the-money = $0, for a total gain of $7
($7 initial credit)
Total profit = $11.

That's how it works. Not only did this trader begin with a credit in his/her account, but he/she made even more money because the prediction was correct. Just remember though, XYZ could have gone up well past $68 in that time frame. In that case, the trader would be short more options than long, so they would have to cover at sometime. (maybe at a loss). With the $3 initial credit, the breakeven would be at $73 and losses would start to occur above that number. With the flat skew spread, the breakeven is at $70 with 2 extra short calls to deal with if XYZ starts flying past $70.

You can see how the skew effect can give you an advantage. So it is in the best interest of every option trader to be aware of the volatility skew. (if there is any). Just check your option chain data before putting on the trade to see if the odds might be in your favor.

Next time, I will discuss more strategies to take advantage of the skew effect.


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