My last “What a Tool” column outlined the basics of implied volatility charts for options trading investors. This go-around let’s dig deeper into the volatility world and tackle the phenomenon of volatility skew (vol skew). When explaining this concept I like to begin with a logic chain of sorts explaining why skew exists.
1. Implied volatility reflects the supply-demand status of an option.
2. A myriad of options are available for any given security.
3. The demand for different strike prices or months will likely vary.
4. The implied volatility will thus differ among the variety of options available, a phenomenon known as vol skew.
The extent to which vol skew exists for any given security can be identified using two methods. First, consider the implied volatility column in an option chain. The lion’s share of tradable securities will see downside puts trading at higher volatility levels than upside calls. An occurrence which makes all the more sense when one considers the predisposition of most market participants to buy out-of-the-money puts as protection while selling out-of-the-money covered calls. Consider the following option chain of the SPDR S&P 500 ETF (NYSE: SPY) July put options:
Notice how the volatility of each individual strike price is increasing as you move further out-of-the-money.
A second method available is using the revolutionary 3D vol skew charts provided by Livevol which allow the ability to compare the volatility of multiple strikes and months in graphical format (see chart below). If vol skew didn’t exist, you would see a flat horizontal line reflecting that each strike possessed the same volatility. When assessing the shape of a volatility graph it’s easy to see why descriptive phrases like “smile” or “smirk” are used.
Because the skew charts are in 3D, users have the ability to view them from different vantage points to get a better idea of their depth. Within the Livevol platform users also have the ability to view a playback of how vol skew has evolved over time. Watching the progression of volatility helps in identifying and better understanding the typical volatility build that occurs prior to important events such as earnings announcements, as well as the severe volatility crush that occurs following the event.
Some traders use vol skew to aid in strategy selection as well as deciding which strike and expiration month to use. Remember, the idea is to buy options trading at low implied volatility levels while selling those with high implied volatility. Here are two examples:
If the front month options are trading at excessively high volatility levels, traders may consider structuring some type of calendar spread involving selling the short term options.
If the out-of-the-money options in one particular month are trading at elevated volatility levels versus the at-the-money options, traders may consider structuring some type of ratio spread by buying the at-the-money option and selling multiple out-of-the-money options.
Like most other option tools the 3D vol skew charts require time and practice to master. But it’s well worth the effort for those desiring to become elite option traders.
Follow Tyler Craig on Twitter@TylersTrading.