By Steve Papale
I don’t like to mess with electricity. Ever since I wondered how hard it could be to hook up a ceiling fan and proceeded to electrocute myself and pop our circuit breakers I get a little nervous fiddling with that stuff. Still do it but am much more careful. The other night I saw a guy on TV take hold of a live electrical wire with one hand and place his other hand on a puddle of gasoline. The current apparently completed the circuit up one hand and down the other and ignited the gas. Ah fun with science.
The last couple of weeks we have been going over vertical skew and the ins and outs of how it affects our trading and how we can use it. Today let’s move from comparing IV’s across strikes within any given month to comparing IV’s across different months. The relationship of IV’s of various strikes across different months in known as the horizontal skew.
As we have said before, it is not the option price per se that we as options traders are concerned about but rather the IV. By comparing IV’s, we can compare strikes and months regardless of delta or time until expiration. The normal relationship of IV between months is as we move further out in time, IV rises. This is largely due to the idea that the longer the time until expiration the more chance for unexpected events to occur and is referred to negative skew.
When the front month IV is above the next month IV the skew is described as positive. This can occur for several reasons including upcoming earnings and large downward moves in the stock. When uncertainty and nervousness occur, traders and investors reach for short dated options more than longer dated options due to more gamma for ATM options, which means more protective power, and cheaper total cost. From a trading perspective it is preferable to sell options that are relatively more expensive than the options that we buy. So from that perspective, a positive skew is attractive the traders looking to place long calendars or diagonals. However, the relative relationship of IV between months is only part of the story. Since vega measures the risk of the overall position of the trade to changes in IV, we also need to look at what each month potential IV move might be and what the exposure for those moves are. More on that next week…