Understanding Volatility Skew And How It’s Used in the Options Trading
Volatility skew is a concept in options trading that has gained traction nowadays. It has been observed that option contracts with different strike prices in the same underlying asset with the same expiration date has different implied volatilities.
Also, options at-the-money have lower IV than in-the-money or out-of-the-money options.
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See the above table. You can clearly see that premium for 100 point OTM CE is far lower than 100 points away PE. The volatility is skewed toward put options. That means the demand for put options is far more than OTM call options.
Volatility Skew: OTM Put > ATM > OTM Call Option
Why Volatality Skew is Created
The primary reason is most investors are long stocks and to hedge their portfolio they buy put options. Also, to earn consistent returns, they sell call options. Markets often crash suddenly and all of these factors contribute to higher demand for put options than call options.
The volatility skew is affected by sentiment and the supply and demand relationship of particular options in the market.
It also indicates how actively fund managers write long call and puts.
Riskier assets (for example, equity) generally have a negative volatility skew. So, if relative skews in particular options series are unusual, traders can exploit this in trading decisions. There are broadly four reasons behind the creation of Volatility Skew:
- Reason no #1 The Big Event, such as Budget, Monetary Policy etc.
Suppose the market is now at the 15000 levels and the union budget is going to happen. And, it has just two possibilities: either it will fall massively or in the best-case scenario, it will go moderately up.
In other words, people are scared of a big fall and worried about protecting their portfolios.
Therefore, what should be the premium for the 14800 Put and 15200 Call option?
Will it be equal? It will not be practical. Since fear is more than greed, the IV of the put option will be higher than the IV of the equidistant call option.
- Reason No #2 Demand for Put Option
Mutual funds and big institutional investors want to buy put more to protect the portfolio and so the demand for puts are always higher than Call options. That shifts the skew toward put options.
The demand for call options is often less as nobody is afraid of the market going up.
- Reason No #3 Interlay of Vega and Volatility
If fear in the market increases, volatility goes up and so the vega. And if vega goes up with the increasing threat of fall in the market, the cost of put premium also goes up.
Using Volatility Skew in Options Trading Strategy
If the implied volatility of the OTM Put option at a certain strike price is more than the same strike price OTM Call option, it indicates the volatility is skewed toward Put options. It gives an idea about demand for Calls and Puts.
The question arises that what does it mean for traders and how they can take advantage of the skew.
Jade Lizard is the most prominent options strategy to take advantage of options skew.
A Jade Lizard is a slightly bullish strategy that combines a short put and a short call spread. It is used when there is mildly bullish or neutral trend.
The probability of success of such strategies is very high. The best time is to use it when expiry approaches, which helps you earn the theta premium.