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Using Option Volatility Skew to Your Advantage: Part One

Using Option Volatility Skew to Your Advantage
Successful option traders use volatility to their advantage on every single trade. Even a basic option strategy, like buying a call, can be statistically helped out when the option being purchased is cheap in terms of volatility. While most seasoned option traders perform an implied historical volatility analysis, some traders don’t go quite far enough. For a complete volatility study, traders must also look at the volatility skew.

Volatility Basics
Volatility is important in valuing options. It helps traders understand whether the option is “underpriced” or “overpriced.” This concept is very simple at its root. Rhetorical question: Would you rather own an option on a volatile stock or a non-volatile stock? Of course the volatile stock provides more potential for movement, so any rational trader would rather own options on a volatile stock than a quiet stock, all else held constant. Because options on volatile stocks are in greater demand, they are more expensive. As the logic flows, it is volatility — or, more specifically, the anticipation of future volatility — that affects the relative prices of options.

We can quantify how much it is reasonable to pay in terms of this volatility premium by studying historical and implied volatility. As many of us know, historical volatility is the annualized standard deviation of past stock prices. It quantifies the numerical value of the volatility that a stock or other asset has recently experienced. Implied volatility, then, is the observed volatility level at which an option is trading. It is viewed as the market’s estimate of the future volatility of the underlying asset. It is the future volatility implied by the market.

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Implied volatility (IV) and historical volatility (HV) are closely watched by traders because how historical volatility acts through expiration will have an effect on the likely profit or loss to the option position being held. The gist of it is that if the stock becomes more volatile than the implied volatility indicated, long option holders have a better chance of having a winning trade because they bought volatility that ended up being cheaper than the asset’s actual volatility.

Meanwhile, short option holders have a better chance of producing a loser because they paid too much for volatility. It’s the same concept if HV ends up being lower than IV: Long option traders are disadvantaged and short option players are better off.

Using Skew
But it doesn’t stop there. The superficial IV-HV comparison performed by many traders is lacking in specificity. It is important to realize that the options listed on a particular underlying can all have differing implied volatility values. This intraclass volatility disparity relates to a concept called skew. To fine-tune, traders need to look at the unique volatility attached to each option in the chain.

Horizontal Skew
When looking at the implied volatilities of options in a chain, it is common to see patterns emerge. For one, the volatilities of the options may differ among the tradable months. When this is observed, there is usually a pattern. Either the front month (the month with the least time until expiration) is higher than the other months creating a cascading effect of each subsequent month having a lower implied volatility than the last, or the front month is lower than the others with volatilities rising with each month going out in time.

The front month is typically the most sensitive to changes in volatility. That is, if volatility rises, the front month volatility tends to rise more than the others. And if volatility falls, front month volatility falls more than the rest. The rest of the months tend to follow in chronological order in their sensitivity to volatility changes. Therefore, the second month experiences the second greatest nominal change in implied volatility, the third month experiences the third greatest sensitivity, and so on.

Long-term options and LEAPS change the least. This volatility differential among the months is called the “term structure of volatility.” The term structure of volatility, then, is either downwardly sloping with the higher volatility skewed to the shorter-term months, or is upwardly sloping with the back months boasting the highest volatility.
The lesson to be learned here is that when deciding which month to trade, one should always consider the term structure.

While most traders are accustomed to accounting for factors such as theta and time horizon of the forecast in planning their trades, term structure is often overlooked. This is a big mistake. Working a term structure analysis into a trade helps a trader to buy the cheapest volatility or sell the highest volatility available among the listed options available.

TO BE CONTINUED IN PART TWO