Skew option strategies

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By Simon Gleadall , CEO of Volcube. One of the factors that affects the value of an option contract is the expected volatility of the underlying product over the life of the option. Now for options that are struck on the same underlying product and have the same expiration date, you might expect that the same expected volatility is used in their valuation.

Options Trading: Volatility Skew, Part II

However, this is usually not the case. The reason is that the supply and demand for options with different strikes but a shared expiration date and shared underlying product, varies. For instance, it could be that there is excessive demand for put options relative to call options because investors are looking to hedge the underlying asset.

Now the only way for traders to alter the price of options to reflect this bias in demand is by increasing the implied volatility in those options that exhibit disproportionate demand. In such cases, we say that the implied volatility curve for this expiration exhibits a put option skew.

Other skew types are possible; the call options could be trading at a premium to put options and this might be termed a positive call skew. Both calls and puts may trade at a premium to the at-the-money options in implied volatility terms and this may be termed a smile.

Volatility Skew For Stock Options

So what is option skew trading? Trading skew means to look to trade the shape of this implied volatility curve.

In this case, he could sell the puts and buy the calls all delta-hedged in the expectation that the skew will move in his favour. Note that this trade a combo or risk-reversal, as it is known , could be vega-neutral.

In other words, the trader is not aiming to profit from movement in the overall level in implied volatility; he may be indifferent to this.

All he expects is that the calls will rise in implied volatility terms relative to the puts. Volcube is an options education technology company, used by option traders around the world to practise and learn option trading techniques.

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