Trading WITH OR AGAINST the Skew - ISE.com

MONTHLY FEATURETrading WITH OR AGAINST the SkewSteve MeizingerWHAT IS IMPLIED VOLATILITY?The options market provides a fascinating outlook onfuture expectations of the value or performance of anunderlying asset. Option prices are disseminated byaggregating these expectations from market participantsfor any given underlying instrument.This market providesmore than just the bullish or bearish view, but also themagnitude (how far) and timing (how fast). All of thisinformation (and more) is captured in what is termedthe implied volatility.Implied volatility can be used to forecast marketdirection and make trading decisions. It changes asinvestor sentiment changes. (The precise forecasting valueis subject to debate for many experienced option traders).Implied volatility is derived from an options pricing model,such as the Black-Scholes model.A basic options pricingmodel uses six inputs to calculate the theoretical priceof an option: asset value, strike price, time left untilexpiration, dividends (if applicable), risk-free interest rates,and, arguably, the most important factor, the volatilityof the asset. When the volatility input increases, thetheoretical option premiums go up.When the volatilityinput decreases, the theoretical option premiums godown. Volatility is a huge factor in an option’s price.Traders should always consider the pricing implicationsfor changing volatilities.All options pricing models make many assumptions, asdo all mathematical models. I will concentrate on thevolatility “assumption” in the options pricing model.The underlying assumption is that volatility is constantthroughout each respective strike price, regardless ofduration.We all know those conditions do not exist!However, it is possible to calculate the implied volatilityof an option. Implied volatility allows traders to comparevarious strike prices over different months. Using thewell-known six pricing inputs, but with some simplealgebraic modifications, the implied volatility can be solvedfor if we use the current options price as a given, ratherthan solving for the theoretical price of an option as in theoriginal model. The implied volatility allows traders togain a very different perspective of the options markets.In general, options based on the same underlying securitybut with different strike values and expiration times willyield different implied volatilities. Since supply and demandultimately drive prices, traders can learn which options are“cheap” or “expensive,” relativeto others, as measured bythe implied volatility of each option.This relative value isdefined as options skewness, or skew.Volatility skew canbe used to identify trading opportunities.FINDING THE SKEWHow can traders find skew? One way is to peruse theoption chains using a pricing model with implied volatilityand finding relatively high or low implied volatilities. Thatseems rather laborious.There is an alternative. Recently,Livevol (www.livevol.com) released advanced functionalitythat allows traders to view the options skew on anyoptions class. The “volatility skew” can be graphicallyviewed by charting the implied volatility across variousstrike prices and months. Another volatility shape thatdiffers from the original pricing assumption that allvolatilities are identical is termed the “volatility smile.”Viewing “skews” and “smiles” is as easy as just clickingon the respective asset you wish to study. Livevol allowstraders to view all option classes so that they can befully informed on the volatility expectations for eachunderlying asset.How can understanding the implications of “skews” and“smiles” help someone make better trading decisions?The graphic representation of all the premium information(think volatility or just “vols”) allows traders to recognizewhere and when the market is expecting more movement(variance) in the underlying instrument.A trader can theneither trade with or against the “skew” or “smile.” Thereare different explanations for the skew; one of the moststraightforward is leverage. Skew is priced to reflect themarket’s assessment of future risk, which takes intoaccount an asset’s current price, pricing trends, and thepotential for a sudden price “jump” in either direction.The basis of skew is that even though options are foundedon a risk-neutral concept, market participants have riskprofiles that affect the supply-demand relationship of theoptions market. For example, many equity and ETF optiontraders tend to sell upside calls and purchase downsideputs (termed an “options collar”) to reduce their overallrisk exposure. Given that many participants have predeterminedpreferences, options with lower strikes tend tohave higher implied volatilities relative to options withhigher strikes.This supply-demand scenario is manifestedin many skew charts.10 | www.expiringmonthly.com

Steve MeizingerMONTHLY FEATURE Trading WITH OR AGAINST the SkewWithout specific preferences, all strike prices and expirationmonths would trade at the same implied volatility.Skew is created by differences in supply and demand inthe options marketplace and is best identified using skewcharts. If you believe the skew is “wrong,” the market iseither underestimating or overestimating the probabilityof a large upside or downside move in the underlyinginstrument.An assessment of the relative risk/rewardtradeoff should always be considered prior to implementingany options strategy.EXAMPLES OF STRIKE SKEWLet me share a few examples of volatility skew using theLivevol.com skew tool.As a personal preference, whenI am looking to analyze the U.S. equity market, I use theS&P 500 ETF (symbol SPY) as a proxy for the market. Inthe example below, SPY is exhibiting significant negativestrike skew. This means that the lower the option strikeprice, the greater both the implied volatility and theperceived volatility of the market.The negative skew hastraditionally been normal for equity markets, although notnearly as steep as in this example. Interestingly enough,the shortest dated options had the lowest volatilities (redand yellow), predicting less movement in the short-termrelative to the intermediate-term.The second example is Apple (symbol AAPL). In thisinstance, the strike skew is evident but not nearly asextreme (the slope of the line is less). In fact, the longestdated options (shown in purple) have a moderate negativestrike skew.Again, shorter dated options were predictingless variance than intermediate-term options. If youcompare AAPL to SPY,AAPL was expected to have more“upside” volatility relative to SPY.In the third example – a gold ETF (GLD) – the strike skewwas not evident. In this case, GLD is a good example ofan option “smile.” The “smile” is apparent when both thehigher strikes and the lower strikes have nearly identicalimplied volatilities. Depending on the time horizon, thesmile is either nearly perfect or a bit towards a negativeskew, with the upside calls having a slightly lower impliedvolatility relative to the downside puts. Generally, GLDwas more of an option “smile” graph of implied volatilities.SIGNIFICANT NEGATIVESTRIKE SKEW - SPYMODERATE NEGATIVE STRIKESKEW - AAPLOPTION SMILE - GLD11 | www.expiringmonthly.com

Steve MeizingerMONTHLY FEATURE Trading WITH OR AGAINST the SkewThe fourth example is a EUR/USD currency pair value(symbol EUU). Currencies price money in relative termsas equities price future earnings capabilities. In this example,the strike skew is negative, especially in the secondand third months (yellow and green lines). Intermediatetermoptions have just a slight negative skew, meaning thatin the shorter term the EUR/USD might be more volatileto the downside. However, over the intermediate termthere is just a slight preference to more variance if EURweakened in value relative to USD.The final example is a bio-tech company, Dendreon Corp.(symbol DNDN).The short-term months (red and yellow)had very low implied volatilities relative to intermediatetermoptions. Can you believe the gap? This is truly aunique situation that manifests itself when the optionsmarket is expecting news that is likely to move the stockin a dramatic way in a few months’ time, but not in theshorter term. One potential explanation for this behaviormight be an FDA ruling about a certain drug/product thatwould significantly hurt the company if the drug/productwere not approved.The greater negative skew in thelonger-dated options illustrates this market perspectiveDECIDING TO TRADE WITH OR AGAINSTTHE SKEWYour trading tactics should be based on your predictionfor market movement, or lack thereof, relative to marketexpectations (in the time period you select). Understandingmarket skewness, or variance from symmetrical pricingmodels, can help you select the best options strategy.In order to manage options positions effectively, it is veryimportant to recognize the conditions where a strategymight fail.How does a trader decide to trade with the skew oragainst it? Trading with the skew is defined as buyinghigher valuation options and selling lower valuationoptions.Trading against the skew is defined as buyinglower valuation options and selling higher valuationoptions. Instinctively, many traders believe that to takeadvantage of skew opportunities they should plan to buy“undervalued” options and sell“overvalued” options.What does it mean to say that an option is undervaluedor overvalued? The valuation of most assets is normallyapproached on a relative basis. Recall the Black-Scholesassumption for options pricing, that volatility is assumedto be constant throughout various strike prices andexpiration terms.SLIGHT NEGATIVE STRIKESKEW - EUUSIGNIFICANT NEGATIVE STRIKESKEW - DNDN12 | www.expiringmonthly.com

Steve MeizingerMONTHLY FEATUREThat's a nice assumption, but it is rarely (if ever) true.Assuming there is a trading skew in most options classes,is it better (more effective) to buy options with lowerimplied volatilities versus options with higher impliedvolatilities? Though volatility differentials tend toexpand or contract over different strike prices and expirationsmonths, these movements are actually tradingopportunities where you can implement your views inthe marketplace. Traders should be wary of making blindassumptions about options being “undervalued” or“overvalued.” Your trading tactics should never be basedsolely on the implied volatilities, but also on your forecastfor the underlying asset considering the risk and rewardtradeoffs offered by the marketplace.What are the trading implications for trading "with" theskew? In this scenario, the market is willing to “overpay”for a certain strike price or time frame.A trader canpurchase the higher implied volatility and sell a differentstrike price or month at a lower implied volatility. Whywould you want to purchase higher-valued options andsell lower-valued options? Your market forecast couldmirror the options market (more demand relative tosupply creates the skew) where you “give away theoreticaledge.” Alternatively, you can trade "against" the skew,assuming you forecasted a symmetric event and wantedto “gain theoretical edge” by selling higher-valued optionsand buying lower-valued options. Trading against the skewis a "reversion to the mean" strategy, meaning that you areimplementing an options strategy that benefits from amore normalized trading scenario (think of symmetricalrather than asymmetric underlying moves).Remember,“cheap” or “expensive” attributions arebased on a symmetric mathematical options model. Forexample, if you believe the market will remain calm in thenear-term but that, in the coming months, it’s going tobecome more volatile, you can implement a long calendarposition.This is considered trading with the skew if theshorter-dated options are priced much cheaper than thelonger-dated options.There are many variations of tradingwith the skew.The only requirement is that the optionyou sold has a lower implied volatility than the optionyou purchased.TRADING ADVANTAGES OF THE SKEWIf traders have an understanding of current marketsentiment, better trading decisions can be made. Withinsight into market expectations, traders can choose totrade “with” the skew/smile or “against” it. Optionstraders need to be cognizant of the important functionimplied volatility plays, not only in pricing, but also as anindicator of potential outcomes for an underlying asset.The options skew is priced to reflect the market’sassessment of future risk. Skew is the impact of leverageon an options portfolio. Traders should draw their ownconclusions based on their financial goals and risktolerance, and should learn how to be as efficient aspossible in selecting not only assets to trade, but alsotheir strategies. Livevol’s skew charts are one tool traderscan use to manage their options portfolios moreeffectively.Options can help lock in your gains and keep your lossesto a minimum. To learn how, go to OptionsEducation.orgor contact your Financial Advisor.Free Options Help Desk | Free Local Seminars | Software | Online Classes | Position Simulator | Strategy ScreenerOptions involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options,available by calling 1-888-OPTIONS or by visiting OptionsEducation.org. None of the information in this ad should be construed as a recommendation to buy or sell a security or to provide investment advice. ©2010 The OptionsIndustry Council. All rights reserved.13 | www.expiringmonthly.com