trade volatility

Volatility Skews Explained

Volatility is probably the most confusion issue that options traders deal with. If that is the case, than the volatility skew is like rocket science to most traders. I want to explain volatility skewing and how a trader can take advantage of this useful information.

As you may realise, volatility is a major factor to the overall price and value of an option. As volatility rises and falls, so does the price of options. Statistical volatility is related to the past ranges of the underlying, as determined through a calculation using a standard deviation in options prices that is averaged. Most people use 21-30 days of data. Implied volatility is calculated using an option pricing model, and takes in to effect the strike price, asset price, volatility, days to expiration, and the risk free interest rate at that time. The result of implied and statistical volatility can greatly differ at times.

Volatility skewing occurs when options of the same underlying have different implied volatility levels. This skewing occurs through supply and demand mostly. This occurs mostly on in the money options as well as out of the money options. In the money options generally have a higher skew due to options price movement, while out of the money options command a higher volatility due to demand for the cheaper option from most traders. This basically means that some option strikes are trading at a higher than normal price when compared to the entire option series. If a trader were to plot volatility on a graph, it would look similar to this.

The graph above is actually taken from recent information in the soybean market. As of this article, Soybeans have a high volatility and a high volatility skew. Notice that the 625 strike has an implied volatility of 30, and that the 850 strike has an implied volatility of a 50. This means that the 850 calls are priced 66% higher than they should be when comparing them to the implied volatility of the 725 strike.

So how can a trader benefit from this information. "Buy Low and Sell High" is a phrase that makes complete sence to volatility traders. If you are spreading options in a market that has a high volatility skew, than make sure the options you are buying are on the low side of the skew and the options that you are selling are on the high side of the skew. By doing this you are further reducing your risk, if you are spreading options at a 1 to 1 ratio. If you are ratio spreading or back spreading, your risk reward may be different, but can vastly improve by researching volatility before entering a trade.