After introducing the concept of volatility skew last week, along with the basics of what a "smiling skew" looks like, I promised this week that we would take our newfound knowledge and show how to apply it to improve our chances for profit, especially when implementing various spread trades. If you missed last week's introduction, you can review it Here.
Since we're going to be talking about spread strategies that some of you will be unfamiliar with, I'll point you to a few spread-related articles that I wrote last year.
More Details on Spread Strategies
Alright, now that everyone is on the same page, let's dive back into the skew effect. Recall from last week that volatility skew simply refers to the fact that the volatility of options on a given security (and for a given expiration cycle) will usually have differing volatilities. One of the most common scenarios is called a "smiling skew", where volatility rises as you move away from the ATM strike. I had planned to continue our discussion with a specific example this week, but I'm going to keep it hypothetical to try and eliminate the urge to find a trade within our discussion. The process of understanding how the concept of volatility skew works is far more important and I want to keep everyone focused in the educational vein -- at least for this week.
Since we showed last week that the effect is the same whether we are talking about Puts or Calls, I'm only going to focus on calls today. Just remember that the concept works either way. Normally the factor that will push us one way or the other (puts vs. calls) is that we will select whichever option (all puns intended) gives us the more favorable pricing for the spread (maximum credit or minimum debit).
Remember that we are using the concept of "flat skew" as our baseline, and from last week's article, it would look like this for calls on a hypothetical stock, ABC currently trading at $50. Note that I have also listed the hypothetical option prices here.
Calls: Strike 40 45 50 55 60 65 IV(%) 55% 55% 55% 55% 55% 55% Price 7.0 6.0 5.0 4.0 3.0 2.0Now if we just change the skew on the stock from flat to smiling, look how things would shape up.
Calls: Strike 40 45 50 55 60 65 IV(%) 57% 53% 51% 54% 58% 63% Price 7.5 6.2 5.0 4.2 3.4 2.8As I mentioned last week, this may not seem significant if you just buy calls for a directional trade. But for spread traders, taking advantage of this skew pattern can really stack the odds in their favor. Let's look at a quick example with a simple Bullish Call Spread, where we are buying one strike and selling a higher strike.
Let's assume that we buy the $50 call and sell the $60 call in the flat skew scenario. Our net cost for the trade would be ($5-$3), yielding a position with $2 of risk (our initial cost) and a maximum potential profit of $10 (excluding commission costs). A reward/risk ratio of 5:1 may seem alright to you, but I like to stack the odds a bit more heavily in my favor. Look what happens if we take advantage of the skew effect.
With the pricing shown in the smiling skew table above, the same spread would shake out as follows. Buy the $50 call and sell the $55 call for a net cost of ($5.00-$3.40) to yield a total cost of $1.60. The potential upside for the trade is still $10, so now our reward/risk ratio is 6.25:1. The other nice thing about this scenario is that our total risk in the trade has been reduced from $2.00 to $1.60.
The skew effect can be used for any type of spread we might choose to initiate. Let's look at a ratio call spread now. Recall that a ratio spread consists of buying the near the money option and selling 2 or more of the OTM strikes, ideally for a net cost of $0 or even a slight credit. Turning back to the values listed above, initiating a 1x2 Call ratio spread using the $50 and $60 strikes with a flat skew could actually be done for a credit of $1.00 (2x$3.00 - $5.00).
Turning to the smiling skew pricing, the same spread would net us a credit of $1.80 (2x$3.40 - $5.00). That fatter credit when initiating the position gives us a bit more cushion should the trade start to move against us, and pads our bottom line as the trade moves in our favor.
Of course these prices are fictional, as we rarely find pricing that is this favorable in the market. But hopefully this concept is making sense from an instructional standpoint. So long as I haven't made this too confusing, you should now see how paying attention to the skew of volatility can really work to your advantage if spread trading is a part of your overall strategy in the market. Hopefully I've convinced you that it is in your best interest to pay attention to the volatility data before putting on that next spread trade.
That does it for this week. Happy exploring and remember, questions are always welcome!