Trading the Skew

Focus: OPTIONS

Lawrence McMillan Image Lawrence McMillan Founder and President, McMillan Analysis Corporation

The levels of volatility skew can make a difference in your profitability, so it's important to understand them and the strategies that work best in various situations, writes Larry McMillan of McMillan Analysis Corporation.

The term "volatility skew" refers to the situation where individual options on a particular entity have different implied volatilities that form a pattern. The pattern usually takes one of two forms: either the higher strikes have the higher implied volatilities (a forward or positive skew) or the lower strikes have the higher implied volatilities (a reverse or negative skew).

Most of the time, $OEX, $SPX and other index options have a negative skew-that is out-of-the-money puts are much more expensive than out-of-the-money calls. The most common place to find a positive skew is in the futures markets, particularly the grains (corn, wheat, or soybeans), although others such as coffee, sugar, and so on normally have a positive skew as well.

There is also a horizontal skew: that is, longer-term options generally trade with lower implied volatilities than do short-term options. This particular type of skew is just a fact of life, reflecting the difficulty of making longer-term volatility projections.

The theory behind "trading the skew" is that you are getting a theoretical advantage by essentially buying and selling options on the same entity (the underlying), yet these options have different volatility projections for that single underlying.