Optionetics: BACK TO BASICS: Volatility Skews and How to Use Them
OPTIONETICS.COM WEEKLY NEWSLETTER
8/29/2005
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MAJOR INDEX CLOSINGS FOR THE WEEK
8/22/2005 - 8/26/2005
Closing Change % Change
NASDAQ (COMPQ) 2120.77 (20.64) (0.96%)
DJIA (INDU) 10397.29 (172.60) (1.63%)
S&P 500 (SPX) 1205.1 (16.63) (1.36%)
Market Volatility (VIX) 13.72 0.30 2.24%
View our complete listing of the indices.
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BACK TO BASICS: Volatility Skews and How to Use Them
By Jeff Neal, Optionetics.com
8/29/2005 10:00:00 AM
When putting together certain strategies, particularly a calendar position, a lot of attention is given to volatility skews. Volatility skews exists when two or more options on the same underlying asset have a significant difference in regards to implied volatility. What this means is that when the options trader compares various quotes of options and looking at each option's contract's implied volatility, there is a big difference between one option and another. If one option has a significantly greater implied volatility than another on the same underlying instrument, the option strategist has a possible trading opportunity that consists of buying the option with the lower volatility and at the same time selling the option with the higher volatility.
There are two types of volatility skews, those being price and time. Volatility price skews exist between differing strikes with the same expiration date. These types of skews are best used in the vertical spreads like the bull call, bull put, bear call and bear put positions, and to some extent even the collar strategy. The other type of skew is the volatility time skew. Volatility time skews exist between different months of either the same or differing strikes. These are used for the horizontal spreads like the calendar and diagonal option strategies.
When using skews to put together a particular options strategy, it is important that the trader understands how implied volatility can impact the trade. For example, assume a trader purchases a call option they may later be unpleasantly surprised to see the stock price move higher, but the call option move lower in what is referred to as a volatility crush. Volatility crushes can be particularly harmful to calendar type strategies and can dramatically shift the initial breakevens rendering a less than attractive position.
In order to avoid these types of scenarios, when putting on calendars with large skews it is important that before entering the position you determine if there is a big event about to happen, such as an FDA approval, management changes, new product announcement or an earnings release. As option strategists, it is best to concentrate on stocks that do not have an upcoming catalyst but still has a significant skew of greater than 15 percent when implementing calendar spreads. This will help from being adversely impacted by a possible volatility crush.
Let us consider a sample calendar spread trade to reinforce the concept of skews. The option strategist implements a put calendar spread with a significant skew anticipating continued sideways to upward movement. In addition, the underlying has no major announcements or events scheduled over the next month. From the table and graph below you can see the trade has a 48 percent time skew with a good range of breakeven prices. These are the types of thought processes an option strategist must go through to consistently profit from volatility skews.
http://www.optionetics.com/images/email/nl08292005.gif
Figure 1: Sample Volatility Skew and Resulting Risk Graph
Happy Trading.
Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Jeff's Forum
http://www.optionetics.com/bbs/forum.asp?forum_id=141&forum_title=Ask+Jeff+N
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WEEKLY OUTLOOK Aug 29
http://www.optionetics.com/articles/article_full.asp?idNo=13126
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ECONOMIC WATCHDOG, Aug. 29
Oil prices rose above $70 a barrel last night and are still up $2 in trading Monday near $68 a barrel.
http://www.optionetics.com/articles/article_full.asp?idNo=13133
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MARKET RANT: A Wishful Real Estate Market
Greenspan's ominous words about the U.S. real estate market probably throws recent American Dream buyers into denial.
http://www.optionetics.com/articles/article_full.asp?idNo=13128
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TECHNICAL TOOLBOX: All Systems � Down
Clare White explores watered laptop territory, and redefines herself in the process.
http://www.optionetics.com/articles/article_full.asp?idNo=13123
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MARKET BEAT: August 29
It�s all about Hurricane Katrina in Monday�s trade, and traders seem to have discounted the impact off key technical support zones.
http://www.optionetics.com/articles/article_full.asp?idNo=13132
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MARKET INSIGHT: Nutrisystem Looking Healthy
The company just recently announced stellar earnings, which at the time of release caused the stock to surge more than 30%.
http://www.optionetics.com/articles/article_full.asp?idNo=13109
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Thank you, have a great week and good trading!
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posted by Victor Lloyd Smith @ 1:27 PM
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