The Problem with Volatility Skew, and Why You Should Care

The jargon of options trading sometimes turns people off, and maybe “volatility skew” is one of the biggest hurdles. So I’m going to explain the concept in a straightforward way, and then explain why volatility skew is something you should care very much about.

Volatility skew usually refers to the difference between the implied volatilities of options at different strike prices in the same expiration cycle. For the majority of stocks and indexes, options with high strike prices have low implied volatilities and options with low strike prices have high volatilities. For example, with SPDR S&P 500 ETF (SPY) trading recently at $136.63, options for April expiration struck at 136 had an implied volatility of 15%. If you look further away from the current price, down to the 125 strike, you’ll see that those options are priced much higher in implied volatility terms — currently, at 21%. That difference between 15% and 21%, roughly speaking, is the volatility skew. 

SPY April implied volatility skew. Source: TD Ameritrade

The reason you should care deeply about levels of volatility skew is that it can make or break your portfolio. Here are two ways that paying attention to skew can have a major impact on your profitability.

  1. Skew curves that are historically flat present excellent opportunities to put on portfolio hedges at a fraction of their normal cost. A very popular hedging method among equity investors is an option collar, which involves buying an out of the money put option and selling an out of the money call option against a long stock position. Hedging methods like option collars are often applied and rolled based only on the calendar. Instead of, for example, rolling an SPX option collar forward every quarter to keep a stock portfolio protected, investors can use skew data to inform those trades. Applying collars when skew is historically flat or low will reduce costs, since the purchased puts will be cheaper than average and the sold calls will be more expensive than average — again, relative to at the money levels. Getting downside protection when it’s cheap and selling upside gains on your stock for a good premium is a great way to boost returns. Additionally, scaling out of collar or put protection as volatility skew becomes steep will maximize gains from those trades. Finally, hedgers can compare the volatility skew among several viable hedging candidates to determine which offers the cheapest options.
  2. Conversely, skew curves that are historically steep present opportunities for great speculative trades — bets that the curve will moderate back to average levels. For speculators, skew is valuable because it presents another avenue for profit that can be traded independently of any forecast about future price or even future volatility. I put on just such a trade in the United States Natural Gas Fund (UNG) a few days ago. UNG put skew was quite high, and the ratio trade we entered was constructed to take advantage of those abnormal levels. Additionally, skew data can inform the structure of other conventional volatility-based trades. Imagine that you believe implied volatility in general is too high relative to likely future volatility, such that a net options sale is in order. You could sell an iron condor with strikes placed far out of the money, or you could put the same amount of capital at risk in a butterfly, selling at the money implied volatility and buying nearby protective wings. When skew is high, meaning that out of the money options are richly priced, the condor trade will have a better expected return; conversely, low skew gives you the clearance to trade the butterfly.

The problem, however, is that simple visual displays of skew don’t tell us whether the curve is historically flat or steep. As I mention in the embedded video above (also available here), simply looking at a skew chart won’t indicate whether there is an opportunity for a speculative trade or a chance to hedge your portfolio inexpensively. A little painless math and some historical data make more thorough analysis possible, and I published the results of such a study in the featured article for the February issue of Expiring Monthly.

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6 Comments For This Post

  1. Darrin Says:

    Hi Jared,
    I read your article in expiring monthly on skew and i thought it was a fantastic summary of the various methods on how skew is calculated. However, when it comes to practical application of trading a steep won’t strategies like an Iron Condor essentially eliminate the very edge that you’re trying to exploit? It seems to me that purest way to trade the skew is through a ratio spread like you mentioned above, but strategies like selling put spreads or iron condors are purchasing options than are more expensive (in vol terms) than the ones you’re selling. Just curious to hear your thoughts. Take care.

  2. Jared Woodard Says:

    Darrin, thanks for the comment and for your kind review.

    It’s true that, as I mentioned in the first part of point #2, the purest way to trade skew is with ratio positions. We can think of ratio trades (back spreads, etc.) as trading the difference between two relatively nearby strikes.

    You’re also right that a condor or vertical spread often involves purchasing options that are more expensive in vol terms – at least on the put side when trading equities; the long calls will usually be cheaper. But the purpose of the condor trade is different – the value of skew information is that it tells us whether the option premiums are rich enough relative to ATM IV to make it worth our while to go OTM. If the answer is no – if the skew is very flat – then we’re better off selling an ATM straddle and hedging with OTM options, since when the curve reverts to normal, vol gains in the OTM legs will be greater. Imagine if the skew is perfectly flat, and we sell a very far OTM iron condor. Assume that overall IV does not change, price does not change (or that these are hedged away) but that the curve reverts to normal. All else being equal, we would expect to lose money on the position.

  3. Suvikas Says:

    Hi Jared
    Very nice article (as usual :)
    What I am unable to grapple with is the Time factor in here. You may be right about the skew (say, it is lower than normal for a put) and buy the put. But the time it takes to revert to normal also ‘leaks’ the time value of the option such that by the time the skew reverts, the trade has lost so much time value as to not being worth it. So, should this skew info be more valid for at least, say, for trades 1 month out (or more) options only?

    Thanks

  4. Jared Woodard Says:

    Thanks, Suvikas. To trade a thesis about skew alone, you would need to isolate other risk factors like delta and gamma/theta. As you noted, if you just buy a put that is underpriced with respect to historical IV skew, the value of the put will also change with time and changes in the underlying. That’s why skew trades are often executed via delta-hedged ratio spreads.

  5. isomorphismes Says:

    Here is my five-sentence simple English summary of volatility skew. Maybe you can let me know if it’s correct or incorrect.

    Stock prices tend to inflate gradually but can fall quickly. For example during Black Monday, 1987, the Dow Jones Industrial Average fell 22% in a single day. The DJIA never rose 22% in a single day.

    So long takes time but short can be immediate. This is reflected in the options chain.

  6. Jared Woodard Says:

    That’s correct, but I think to explain the persistence of IV skew, we have to say something about who is in the market. If not for the overwhelming long bias among equity investors, we might expect IV skew to fade over time.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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