OAP 137: The Ultimate Guide To Option Skew & Volatility Smile

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Implied volatility in option pricing is one of the most critical and yet least understood aspects of this business. Today show focuses on a deep dive into options skew and the volatility smile for both inter-month and intra-month option contracts.  in addition, we'll talk very specifically about the impact of skew as expiration approaches and how Vega for near-term option contracts increases dramatically which can make it seem like option skew is predicting a huge move right before expiration - but is it really the case, and does this "predictive power" work in reality?

Key Points from Today's Show:

  • We assume that the markets are not normally distributed, and that there is an embedded skew.
  • However, a normal distribution is a great learning tool for understanding options strategies. 
  • When it comes to option pricing, there is a little bit of put-side skew or negative skew that occurs. 
  • This has to do with the concept that over time, more often than not, if a stock is going to go down it will crash down violently and fast. When the markets go up, they tend to float or naturally go up at a steady pace. 
  • This is where the idea of volatility skew comes into play.

Volatility Skew

1. Volatility

  • This is the actual implied volatility of different option contracts.
  • The embedded implied volatility that is present at any given time when we're looking at volatility skew
  • What is the expectation of volatility of that contract for that strike price and expiration date going out into the future?

2. Skew

  • Skew refers to the difference between one strike price and another or one expiration and another.
  • Often people wrongly assume that "skew" means twisted or backward, or not meant to be like something went wrong — this is not the case.
  • All skew refers to is that something is asymmetric compared to some other strike price or expiration date.

*It is just about the perceived risk of something happening on one side of the payoff diagram versus the other.

  • Usually, we see this happen a lot in equity index options because many institutions will use options as a hedging technique.
  • Institutions will buy options contracts that are out of the money on the put side, which then increases the price of the out of the money put options. 
  • However, it is too costly to buy them outright, so they generally sell call options that are out of the money to help finance that cost - a simple synthetic collar strategy. 
  • If they buy up the put options, then that is increasing the price of the put options and they are selling call options, which is decreasing the price of the call options because of the selling pressure.
  • That naturally is going to create some sort of skew in the pricing of those option contracts. 
  • This skew, again, is more geared toward the put side.

The Skew

1. Intra-month Skew

  • This refers to the skew between individual strike prices in a single expiration month.

2. Inter-month Skew

  • This looks at the volatility, generally, between the front month expiration and a back-month expiration. 
  • Example: when you get into an earnings event, the week that the earnings are announced, the volatility for the weekly contracts go through the roof. 
  • Because the out of the money call options are generally priced cheaper, and puts are generally priced a little bit more expensive, that's what creates a little bit of this pricing skew. 
  • Again, this is normal to have.

Inter-Month Skew

Example: Looking at the August expiration for SPY, the SPY is trading at $280. Contracts that are $10 out on either end, the call options at $290 are priced at $15 a piece. The $270 put options are trading at $85. This is a huge discrepancy in pricing, which shows the volatility skew that is present in the market to the put side. As we go further and further out of the money on the put side, the option prices do not reduce their value as fast as on the call side. 

Looking at $5 increments between these two, the value of the $285 call options is $78. For the $290 call options, the price drops to $15. This is a pretty drastic, and almost waterfall effect of option pricing as you go further out on the call side. Again, the reason for that is that markets generally do not have this crash up effect - they generally only float higher. 

On the put side, looking at the $275 put options, the price is $140. The price of the $270 put options is $85. It's not until you get all the way down to the $240 options on the put side that you find put options that are the same price as the $290 call options at $15. 

Intra-Month Skew

Example: Looking at the skew between August and September, now we start to see a little bit of that skew start to subside and maybe flatten out if you graph it. The skew between strikes as you go further out in time and the skew between option months starts to flatten out. You get a really high smile effect, but as you go further out in the time it tends to flatten out. At that point, there is so much time for the stock to move that we don't have as much skew. 

In the case of the differential between August expiration and September expiration has about a 2 point differential in volatility. The volatility expectation generally for August is about 12% volatility. The volatility expectation in September is about 14% volatility, but much flatter across all the different strike prices. You don't have that dramatic waterfall effect on the call side as you go out to September expiration as you do with August expiration.

Volatility Smile

  • Most people misunderstand what these volatility smile lines really represent when it comes to the differences between the different contract months: intra-month volatility smile. 

1. A Line that Resembles a Smile

2. The Skew

  • Often times people look at volatility smile for expirations that are very close and see that the option prices are creating a smile effect, which means that the volatility that's baked into both the call side and the put side is very very high. 
  • This does not necessarily mean that those option contracts are a better deal.
  • In fact, as we approach expiration, option Vega decreases because longer dated option contracts are more tied to changes in volatility.
  • As we get closer to expiration, the impact of volatility on an option price goes down.
  • A small change now could have a big impact six months down the road.
  • When you look at Vega as you're approaching expiration, it doesn't make that big of a difference on the overall trajectory.
  • Later stage changes in volatility have lower and lower impact on the option price.
  • This means that the lower the Vega and the lower the option price, it requires a much larger change in volatility to change that option price dramatically - a huge volatility event.
  • Option contracts that are out of the money and close to expiration naturally have really high implied volatilities.
  • This is not because the options contracts are insanely overpriced - it's just because they require a huge change in volatility to ever make any money.
  • This is also why you see volatility on both ends of the spectrum for closer-dated option contracts.
  • For weekly contracts, we see volatility really expand as we get out of the money.
  • A 1% or 2% move can be done in a day or two on a weekly contract.
  • But a multi-month move on a monthly or bi-monthly contract might mean that the stock floats higher and could crash lower at a much greater magnitude.
    That's why when you look at longer-dated option contracts, their volatility skew is much flatter.

How To Use Volatility Smile

  • Understanding the impact of intra-month versus inter-month volatility is really important.
  • If you understand how skew works and you do see that there is an enormous amount of put skew on a given expiration month, it means that those put options are much higher priced.
  • So selling puts or put spreads can be a little bit more profitable.
  • You can also use it to realize how far to slide strike prices for a strangle

Example: If you set up a strangle $10 out on either end, you will naturally get some skew on the put side by selling the $10 out put options on SPY versus the $10 out call options. You can use Deltas as your proxy for where to set your strike prices. Deltas allow us to naturally account for skew in the market by selling the same Delta on either end of the stock. 

In the case of SPY for the August expiration contracts, if we were going to sell the 15 Delta options on either end, then we would be selling the $286 call options (stock trading around $280), and then the 15 Delta put options would be the $270's. Delta will naturally account for skew, making our put options a little bit further out and bring our call options in a little bit more. 

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
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  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
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Option Trader Q&A w/ Julio

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Julio, who asks:

At the end of 2017, I trade an Iron Condor on TSRO. Within a few days of trading the Iron Condor, the profit line was actually taller than the actual Iron Condor itself. As in, the current profit had I sold it was higher than the max profit. Is that possible?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.