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Focusing on Volatility Skew

When buying or selling options the skew can make a large difference in the profitability of a trade.  The vertical skew refers to the relative pricing of options that are at different strikes but have the same maturity.  If the implied volatilities at a strike which is 95% of the current price are higher than the implied volatilities at 105% of the current underlying price then the option is said to exhibit reverse vertical skew.  What this really means is that the downside options are being priced more aggressively to put more premium on fast downward moves, which intuitively makes sense.

The key is to take advantage of the skew to the best of your ability when trading implied volatility.  If you are going to buy a put option for downside protection, then you would prefer that you are able to sell an out of the money call option at an implied volatility level which is close to the implied volatility level of the purchased put option.  This would only happen if the volatility skew was relatively flat.

Likewise, if you are selling a put to subsidize a call option purchased on the upside, you would prefer that the skew be sharply reverse vertically skewed so that the sold put option more than offsets the call option premium paid.

If the market that you would like to trade does not exhibit the volatility skew that is most beneficial to your desired trade, then it’s a great idea to look elsewhere.  A great example of this is shown by currently looking at the S&P 500 skew versus asian market skews:

Asian Markets much flatter than the S&P 500

Asian Markets much flatter than the S&P 500

The FXI ishares FTSE/Xinhua China 25 ETF (bottom chart) has a much flatter skew than the S&P 500 (top chart).    The 110% out of the money vol level for the S&P 500 is 17.6% lower than the ATM vol level whereas the 110% out of the money vol level for the FXI is only 7% less than the ATM vol level.  This means that it is more attractive to sell an out of the money call option on the FXI and buy an ATM put option on the FXI all else equal.

In addition, the relative volatility level of the FXI is attractive because it is twice as volatile as the S&P 500 yet is trading at an implied vol level which is less than half that of the S&P 500.

For these reasons, I have been using Asian markets to hedge downside exposure in US Markets.  Yes, I am taking on basis risk by doing that but for the most part the international markets move uni-directionally in large downdrafts.

Posted in Derivatives, Markets, Trading Ideas.

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