Last time we discussed what exactly volatility skew (or smile) is and why it exists (scroll down to my 5-23 blog if you’d like to re-read it). As I finish skew discussions, I almost always get the question: “So what! How is this going to help me trade?” Without getting into the “the more you understand a subject the better you will be at it” debate I can clearly show how using skew can produce an ‘edge’ on a either a speculative or an income spread.
Suppose a trader is looking to get long SLV in a very short term trade. Not wanting to put on a huge position the trader decides to buy a tight vertical. The trader has a whole host of strikes that he or she can chose to buy or sell. How does he or she decide? Take a look at this chart from LiveVolPro:
Do any strikes seem to be over or under priced relative to one another? If you answered yes, you are correct. Either the 35 calls seem cheap(relative to the 34 strike or 36 strike calls), the 36 calls seem expensive or some combination of both. What we do know is that I would not want to buy the 34 calls to sell the 35’s and I would not want to buy the 36 calls to sell the 37s. Both of these spreads would be buying relatively expensive IV and selling somewhat cheap IV. Since the traders goal is to buy low and sell high those two spreads are somewhat unfavorable. The 38/39 spread seems okay, but that is somewhat far out of the money and even if it did have edge, is likely not to win. Take a look at this montage from LiveVolPro:
This leaves us one clear choice, the 35-36 call spread seems like the best value. With SLV trading 35.29 we can buy this one point vertical for about .47, a .18 premium over parity. I like those odd which is out of the money, under normal circumstances should be more than marginally cheaper than a somewhat in the money call spread, it’s not. For a spread that is far less likely to be successful the trader only saves about 11.
Obviously, this is not fool proof, in the end the trader is probably doing better on the 35/36 spread relative to the 36/37 spread by a grand total of .02-.03 a spread. But, when you think about it that probably pays for most, if not all the commission. Take a look at your commission last year, if you could add that to your returns, how much better would your returns have been?
These concepts also apply to non-directional trades. You can read more about skew on my blog http://www.optionpit.com/blog