OPTIONS

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. Obviously, those volatilities must eventually converge-one option is, by definition, overpriced with respect to the other. There are some subtleties to this theory, but the general idea is a valid one.

Traders who "trade the skew" generally use a spread-buying the cheaper (lower implied volatility) options and selling the expensive (higher implied volatility) ones. They are looking for the implied volatilities of the options involved in the spread to converge at or before expiration. This is quite possible in a vertical spread-where the options expire in the same month. Even if the options actual implied volatilities never do converge, they must do so on the expiration date, as they lose their time value. Hence bull spreads, bear spreads, ratio spreads, and backspreads are favored strategies. More will said about them in a minute. On the other hand, the horizontal skew does not have to disappear by expiration, since the options don't expire at the same time. Sometimes, calendar spreaders are attracted by a very distorted horizontal skew, but there are other things that are perhaps more important in that strategy.

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