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Educational Article

A Skew Refresher

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By Lee Lowell

In my last column we talked about ratio spreads and how important it is to find options with the correct "skew" to ensure maximum results. I have some friends who still ask me about skew and what it is and how it comes about and how to use it correctly. So I want to use this week's article as another skew review.

Every option that is available for trading has a component within its pricing structure called "implied volatility." You can solve for this number by using an option calculator. You enter in all the known values for the specific option you are interested in, and then the calculator will give you it's implied volatility at that moment in time. It is an ever-changing number. The implied volatility of that option is a prediction by all the options players of how they think the underlying stock or index is going to fluctuate over the life of the option. Implied volatility is also an indicator of how expensive or cheap those options are relative to its past behavior. In my experience, and according to most other option players, the at-the-money (ATM) options are the most widely used when assessing the "overall" implied volatility of that specific market.

You would think then that every option available on the same stock should have the same implied volatility, right? Not necessarily. But when they do have the same IV (implied volatility), this would be called a "flat skew" and some stocks do exhibit this pattern, but not many. Usually every option on the same stock or index will have a slightly different IV than the next strike above and below it, and have a greater IV differential than the strikes a few dollars away. Why does this happen is the most common question. It is because of speculation and emotion of the market players. When traders feel they know which direction the market is headed, they will purchase cheaper, out-of-the-money (OTM) options (puts or calls) in large quantities. When the market makers on the exchanges get swamped with larger volumes of these OTM options, the only way to protect themselves is to raise their ask prices on the contracts. This in turn bumps up the IV on those specific strikes. The IV on those particular strikes will see its level move up or down more than its neighbor options, thus causing either a "forward skew", a "reverse skew", or what I like to call a "smiling skew."

A forward skew is a pattern that occurs when each successive higher strike option has a higher IV than the strike below it. A reverse skew is when each successive lower strike option has a higher IV than the strike above it. And a smiling skew is a pattern that incorporates both a forward and reverse skew that starts from the at-the-money options.

Here is an IV skew chart of a random security. It's easier to see what I'm talking about when you visualize it graphically. The strike prices are on the bottom and the volatility levels are on the sides. This a typical smiling skew graph. This particular security is trading for about $28.50 and its ATM options are the cheapest on an IV basis. As you move higher and lower with its strike prices, the IV gets higher in both directions. The little blue squares are the actual IV of each strike as of the close of trading from Friday. The solid line is basically a connect-the-dots line to show you the pattern.

This is all well and good, but how does skew help our trading? Skew patterns are very helpful when instituting option spreads. When looking at the IV for each option in your spread, it will tell you what kind of advantage or disadvantage you will be playing with. If the options have a flat skew, then you will be buying and selling each option in your spread at the same IV, and there will be no advantage/disadvantage to your strategy. If you buy the long side of your spread at a lower IV than the sell side, then you have an advantage. Take a look at the Applied Materials (AMAT) put option chain (we used this last time too, but prices are updated).

With AMAT around $52, that would make the $50 and $55 puts the closest ATM strikes and thus should be somewhat similar in its IV. Again, if you look at the "Imp Vol(B)" and "Imp Vol(A)" columns, these are the implied volatilities in percent based off the actual bid and ask prices respectively. For the most part, AMAT is exhibiting a reverse skew where the IV's get increasing larger as we move from the higher strikes down towards the lower strikes. The skew does start to flatten out as we look at some of the highest strikes.

The best way to take advantage of this skew would be to implement a bear put spread if you felt that AMAT was going to move lower over the near-term. This would allow you to buy a cheaper option and sell a more expensive option on an IV basis. The spread would still be a debit from your account, but it is a smaller debit due to the favorable skew pattern.

For example, we can buy the July $50 puts at $3.80 for an ask IV of 60% and sell the July $40 puts for $1.05 at a bid IV of 70%. This is a very favorable bear put spread in terms of skew. We bought our long leg at 60% IV and sold our short leg at 70% IV for a total debit of $2.75. So what, you say? Well, let's see what would happen if AMAT was showing a forward skew where we'd buy our long leg at a higher IV than where we'd sell the short leg. Just for example sake, I ran some numbers through my calculator and wanted to see what the spread would be worth if we bought the $50 put at 70% IV and sold the $40 put at 60% IV. Using those values, the $50 put would now be worth about $4.35 and the $40 put would be worth about $.60, making us now pay $3.75 for that bear put spread. That's a full $1 dollar higher than when we purchased it when AMAT had the reverse skew.

It is imperative that you check IV before initiating any kind of option spread to see what your chances look like. It doesn't mean that you can't put on the play even if the skew is unfavorable. Just know that you will be starting at a disadvantage if you do.

There is also another reason why certain strikes exhibit different IV's from its neighbor strikes. If AMAT is at $52 currently, and the ATM $50 put options have an IV of 59.5%, this tells us that the market thinks AMAT will move about 59.5% above or below where it is today over a certain period of time. At the same time, the OTM $40 puts have an IV of 70%. What this might mean is that if AMAT starts tanking and is trading at $40 next week, then the $40 puts will become the ATM strike and the market will now think that AMAT can move 70% above and below where it is today. Make sense? Once a stock or index starts fluctuating around, then IV usually goes up because traders feel that bigger moves can happen. This is why OTM options can have a much higher IV than the current ATM option. Because if the stock moves quickly towards that OTM option, the market will re-price the options with higher IV's knowing the stock has the ability to blast through strikes with ease. So the market makers want to be compensated for that by raising their asking prices.

This may seem confusing to some but it is a good concept to learn about. Implied volatility is alive and well in the options market and it is primarily how I base my own trading decisions. If an option trade ever went against you even though your call on the direction was correct, I'll be it was because you didn't check the IV level of the options beforehand.

Good luck.

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