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"Volatility skew re-visited"

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By Lee Lowell

I would like to thank all the readers for the kind words you've e-mailed me and for all the great questions too. I want to devote part of this week's article to answering some questions that I feel might benefit most of the readers. Plus we'll get into more examples of using volatility skew.

First I want to clarify one of the calculations I made in last week's piece. Thanks to a very sharp eye of one of our readers, I want to further explain the point I was trying to make. If you followed me on the ratio spread examples using the flat and smile skew, I did use incorrect numbers for the break-even points. But the numbers that I published were meant to make a different point. My break-even numbers were $73 and $70 respectively for the 1x2 and 1x3 call spreads of XYZ corp. What I really wanted to say was that your profits on these spreads start to diminish at these levels. I should not have said that those numbers were the break-even points. The real break-even points were $83 and $75 respectively. Thanks for looking out!

I've gotten a lot of questions on how to go about finding options with certain skew characteristics. Unfortunately there is no way of finding or filtering out stocks with certain skew shapes. I am continuously searching for such a helpful tool. The only way to know what kind of skew your stock exhibits is to look at the implied volatility numbers associated with each option in the chain. You can then compare each strike's volatility to the others in the chain within the same month and against other months. You will either see most of the options within same month as having the same implied volatility (flat skew), or you will see each strike having a different volatility number (smile or variation skew). Look at the spreadsheet below. This is a custom spreadsheet that I had someone design for me to use with MS Excel.

This is a spreadsheet for Cisco April call options. In another section of the spreadsheet, (which I did not put here) it has all the information on the underlying security itself, i.e. last price, change, high, low, etc. For the spreadsheet above, all the option information I need is right here. I've got the strike price, days to expiration, bid & ask price, and the two most important columns show "bid implied volatility" and "ask implied volatility". Like I've been saying to most of the readers - if you want too be a serious option trader and put the odds on your side, you need to have good implied volatility data. Some datafeed vendors will just give you the implied volatility figure based on the last trade of the option. Well, that is really of no value because the last trade could have happened days ago. You need to know what the bid implied vol. and the ask implied vols. are because it is current and you can compare it to the other strikes and and to its past history too. This is why I have this custom spreadsheet.

Let's take a look at the chain above. Cisco was trading around $132/share, so the $130 and $135 calss are closest to the money. What kind of skew is Cisco showing? Look at either the "imp vol bid" or "imp vol ask" columns. Above $130, the volatilities start to decrease and below $130, the volatilities start to increase. So, from the ATM (at-the-money) $130 strike and lower, the volatilities slope upwards and the strikes above $130 slope downwards. This could be a classic case of where many people are writing covered calls. As holders of the underlying stock, you sell upside calls against your position. If enough people are doing this on the same stock, it will drive down the premiums on the calls therefore lowering the implied volatilities. At the same time people are long the underlying, they may also buy puts for added insurance against a down move in the stock. As more people buy the puts, this increases their premiums and the implied vols at the same time.

These last two columns that show the bid and ask volatility are easily attained. Just as you can figure out the implied volatility by using the most recent option price, you can figure out the bid and ask implied volatility too. By using the actual bid and ask price of the option, you then run it through the Black-Scholes model and it will spit out the bid or ask implied vol. This spreadsheet is Excel based and can be programmed with a Black-Scholes model to do such calculations. I also have this spreadsheet connected to a real-time datafeed so it is updated continuouslt tick for tick. This done using the Excel DDE link that is compatible with certain data vendors. I highly suggest this for all serious option traders.

Even though the chain above is for the calls, the chain for the puts will have the same charateristics. The lower strikes will have higher vols than the closer-to-the-money purs. This is where doing debit put spreads would give you an advantage from the start because you'll be buying an option with lower volatility than the one you're selling. If you have access to historical volatility data, you can compare the levels seen in your option chain to the past levels, and instantly know where these options are trading relative to its past. If it's in the low end of its historical range, buying options would be a good play. You could outright buy calls or puts, dpending on your outlook for the stock's future direction. If the volatility is in the high end of its range, look for selling strategies. Or if you still want to buy options when its volatility is high, make sure you do spreads. This way you'll be buying and selling high volatility which can minimize the negative effect of a volatility drop.

This is how I conduct my research for my own options trading. I've been asked the question of what my routine is like before I actually take a position. Once I've decided on a stock I'm interested in, I'll check the chart patterns and then look at the option prices. I then look at the past historical volatility levels of the underlying and the past implied volatility levels of the option. Looking at these numbers on a graph is really helpful. I'm still looking for the best vendor that shows this type of data. Usually, both the historical volatility and the implied volatility will move in tandem with each other. Most of the time, the implied volatility will be higher than the historical because it's a projection of the future price range of the stock. Most market makers and traders are unwilling to bring the implied volatility down lower than the historical because everything is still unknown about the future. Nobody wants to sell options too cheaply or below its historical range. That could be costly.

If the implied and historical are moving in the same direction, I then compare the implied to its past levels to see where it's at. I only concentrate on the implied volatility at this time. If you're going to trade the option, you'll either buy it or sell it based on where it's trading in the marketplace. And those prices in the marketplace are based on implied volatility. It doesn't matter at this point how the historical vol. compares to the implied vol. What matters is that you know where the implied is compared to its past.

The only other pattern you need to look at is if the IV (implied vol) and the HV (historical vol) are moving in the opposite directions. I touched on this briefly in the last article. What will usually happen is that implied will start to make a move higher but the historical will stay the same. This is due in part to speculation on the near term future of the stock. There may be some rumors flying around, maybe someone got some inside information, earnings are due out, or the Fed is having a meeting. All these factors will lead to a temporary bump higher in the IV which is where the disparity can be seen when compared to the HV.

I want to show you a graph of a smiling skew. Someone e-mailed me and asked if I could include graphs with my discussions.

This is a skew chart for AOL. AOL closed around $61/share so that means $60 is the ATM (at-the-money) strike. The calls are on the left and the puts on the right. You can see that the further you move away from the ATM strike for both calls and puts, in both directions (higher and lower than the ATM ), the IV gets higher. This is a classic "smiling skew". The best ways to take advantage of the smiling skew is to use the strategies I discussed last time. And next time I will discuss how to use the other skew patterns in your options trading as I've run out of time for this week.

Good luck.

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