By Steve Papale
I know I always say I don’t like talking about the weather but alas here I go again. Last week, the high school delayed classes two hours due to cold. It was -8. Cold but it is February in Chicago. Ironically the middle school and elementary school did not get late starts. So when my 15 year old boy was in his warm bed at 7:30 am, kindergarteners and 1st graders were walking to school and waiting for the bus. I can’t make this stuff up.
Last week we talked about vertical skew and why it exists. To recap, vertical skew is the price relationship between strikes within a given month as measured by implied volatility. In equities and equity indexes, the lower the strike, the higher the IV due to the crash fear as we discussed last week. So that’s all and good but how does an options trader take advantage of the skew? There are basically two answers to that question.
First, the lower we sell options down the skew (strikes) the more economic edge we collect relative to the higher strikes. So if we have a chronically overvalued underlying like the SPX, selling OTM puts can be statistically profitable. Remember that when IV is over statistical vol that means option markets are pricing more risk into the options than the underlying is actually measured at. However, if markets collapse these puts will still go up and we can get hurt, as anyone who sold puts in that scenario can attest. However, by getting paid more that we should have, it may lessen the blow just a bit.
Other traders may take advantage of the skew by selling the higher IV strikes and buy a lower IV strike. In the case of put, buying a put spread. The way to really capture this edge however is to hedge the trade, meaning flatten the deltas out by buying or selling the underlying. In this way, the directionality is taken out, at least from the initial delta perspective. This strategy is what is used by market makers when trading inventory and further assumes vols don’t change and gamma can be scalped to pay for theta.
Most retail traders give up some edge trying to do it and is not as easy as it seems. So recognize the skew, sell the expensive options when feasible, but recognize always that the underlying will drive the trade more than anything. Don’t get too caught up in skews and look more at risk and what happens when the underlying moves to a particular level. Next week – the horizontal skew.