At Option Pit one of our major educational focuses is teaching traders to use volatility and volatility skew to improve both directional and non-directional trading. You would think my services would be in constant demand, except for one problem…many traders don’t know that volatility skew exists, let alone understand what it is. In this post, the first in a series, I will explain what the two major IV skews are and why they exist.
Volatility skew is the phenomena where different strikes in a contract month have different implied volatilities. For example, if I look at the IV’s of the 5 nearest ATM strikes in the IBM June contract month the implied volatilities are as follows:
While there are other causes for this occurrence, the main driver is supply and demand. Namely, there are more traders looking to buy insurance below IBM’s price to protect against the underlying falling than there are traders looking to protect against IBM’s underlying price rallying. If one takes the time to look through equities as an asset class, almost every single equity and equity index has a similar skew structure. Traders in equities all seem to be doing this same thing, buying puts to protect against a crash and selling calls to pay for them (traders do not mind selling the call because in theory the ‘slow creep up’ makes calls a sale). I like to call this ‘The Collaring Effect.’ I call the skew structure itself an investment skew, since the driver of the structure is investors protecting themselves against the underlying asset falling. Here is a picture of investment skew from LiveVolPro:
While there are other types of skews, the other really important one I would point out is a commodity skew. This skew is caused by the fear of the underlying rallying over the underlying falling. A good example is crude oil. Crude oil has use in all sorts of products besides gas, parts of crude are in just about everything one could imagine be it a plastic toy or even some clothing. To keep things simple though, imagine an airline. When crude falls, it makes jet fuel less expensive, and airlines like when that happens. On the other end when crude rallies, jet fuel rallies. This makes jet fuel far more expensive and can kill profits. To protect against this risk, airlines will buy Oil calls and sell oil puts to finance the expensive call. This can be seen in the oil etf USO.
Another product that has a ‘commodity skew’ is the VIX and GVZ product. Much like oil, those that trade options and stocks are usually not happy when implied volatility rallies. After all, when stocks fall usually IV rallies and when IV falls, usually the market is rallying. This causes traders to buy upside calls and sell puts to finance those calls. A look the IV structure of VIX options and one can clearly see where the demand for options is.
There are about 10 more IV structures; these are just two of them. By taking the time to learn how the skew structure moves traders can find better value in the options they buy and sell. Finding better value, usually leads to better returns.
Next time I will discuss how to use skew to improve a directional spread. I also have a video on the subject on my blog http://www.optionpit.com/blog