Volatility Skew: How to Profit From Unbalanced Implied Volatility

Volatility Skew: An Introduction

Options traders need to understand various concepts to succeed in the market. One critical but sometimes overlooked concept is implied volatility (IV) and the skew it creates. Options with differing strike prices within the same underlying security can have different implied volatilities, leading to a volatility skew. This article will discuss how volatility skew forms, how to identify it, and how to profit from it, specifically when using credit put spreads.

What is Volatility Skew?

Volatility skew exists when options with different strike prices have differing implied volatilities for the same underlying security. A skew is typically upward (positive skew), meaning that out-of-the-money (OTM) options have higher implied volatilities than at-the-money (ATM) or in-the-money (ITM) options. The opposite situation (downward or negative skew) is less common but can happen. For example, OTM call options might have higher implied volatility than ATM or OTM put options for the same underlying.

Why Does Volatility Skew Occur?

Volatility skew is a result of supply, demand, and market expectations. Market participants (typically large institutions) can drive skew through their activities. For example, protective puts are often used to hedge large portfolios. As a result, demand and implied volatility are usually higher for OTM put options. Additionally, some strategies like straddles or strangles can also significantly affect volatility skew.

Credit Put Spreads and Volatility Skew

Credit put spreads involve selling an OTM put option and buying a further OTM put option for the same underlying security with the same expiration date. This strategy allows traders to profit from premium decay (time erosion) when volatility remains stable or decreases. However, as implied volatility increases, the premium erosion is less predictable, which can impact the credit put spread's performance. Therefore, understanding and managing implied volatility and volatility skew are vital for successful credit put spread trading.

Advantages and Disadvantages of Volatility Skew

Advantages:

• Potential to capitalize on market overreaction or fear, causing increased demand for protective puts and driving up implied volatility.
• Identifying a positive skew allows a trader to sell OTM put options for a higher premium than ITM or ATM put options.

Disadvantages:

• Improperly managing volatility skew can negatively impact credit put spread performance due to unexpected increases in implied volatility.
• Volatile markets can increase the risk of assignment for sold options.

Recap and Conclusion

Volatility skew is a valuable tool for options traders, particularly those using credit put spreads. Understanding how to identify, measure, and take advantage of volatility skew, as well as mitigating its disadvantages, can lead to increased profitability. As implied volatility and volatility skew play a crucial role in credit put spreads, traders must be attentive to these factors when entering and exiting positions.