Successful options trading strategies often require a combination of Market factors aligning in the right order for them to work.
Almost all options Traders rely heavily on volatility and implied volatility metrics when they build their models because Market perception and sentiment can have an outsize influence on inter-day strike prices.
Volatility skew is an important but often overlooked metric when it comes to pricing out and options strategy.
At its core, volatility skew is the difference between implied volatility between contracts that expire on the same date for the same underlying security and different strike prices.
Today we will dive into how volatility skew fits into implied volatility and how you can use it in your trades.
Whether you are an options novice, or an experienced Trader, you should understand the vital significance of implied volatility on options pricing.
Implied volatility does not have an exact measurement; instead, it is an estimate calculated by the black-Scholes equation and its different variations that Traders use to factor in their profitability analysis.
Implied volatility is essentially measuring how the market believes and options price will fluctuate over a given period.
Options contracts with high implied volatility are most likely going to experience High trading volume. Their price may experience more significant fluctuations than a similar contract with lower implied volatility.
Traders also use implied volatility to gauge overall Market risk for a given contract.
Implied volatility was thought to be similar for contracts with the same expiration date and underlying security across various strike prices.
However, in practice, traitors realized that volatility would increase the farther out of the money strike prices became for put options — this is where Volatility Skew comes into play.
Instead of implied volatility being the same across the board for options for the same underlying security with the same expiration date, a skew towards Option prices associated with downside market trends became apparent.
Out-of-the-money puts that would pay off during bearish market conditions, we’re consistently more expensive than their bullish call counterparts.
This skew indicates investors’ willingness to overpay for portfolio insurance and hedges rather than speculative potential for Outsized Returns on calls.
Under a normal distribution, one would assume that the volatility would remain consistent for the same expiration options on the same stock. However, it has been observed that this skew.
Investors often utilize options to hedge longer-term investments in equity indexes or broader Market ETFs.
When volatility skew is heavily concentrated on the lower strike prices, this is called reverse skew.
Reverse skew May indicate bearish Market sentiment or investors taking precautionary measures on their long positions.
Forward skew depicts a positive correlation between implied volatility and Rising strike prices.
In markets with smaller Supply, such as Commodity markets, the implied volatility increases on strike prices increase.
If there is more demand than Supply for the underlying security or commodity, prices will increase rapidly, which will be reflected in the increased volatility.
When Traders look at graphical representations of volatility, they May refer to “smiles” and “smirks.”
A volatility smile is a more balanced representation of volatility where at the money options have lower implied volatility, and options farther out of the money I have increased volatility, which makes the graph resemble a smile.
If there is a skewed volatility, the “smile” will Savor One Direction, which looks more like a smirk.
Volatility and skew can seem complicated, but understanding implied volatility is critical for all options Traders because it can inform your trading strategies and provide insight into what the rest of the market is thinking.
Volatility skew is a unique indicator that can alert traders to potentially over-priced puts, which may provide a lucrative selling opportunity.
If you see a large put skew towards expiration, selling a put spread may be a great way to capitalize on the inflated prices.
Here at Lantern, we want to demystify options terminology, so our users are equipped to make informed and profitable decisions in their trades.