SKEW

[00:00:00.05] - Speaker 1
In the previous lesson, we studied the term structure. The term structure helps us understand how volatility change is in the same strike but with different maturities. In this lesson, we will focus on the skew. The skew, unlike the term structure, helps us understand how the volatility changes on the same expiration but with different strike prices. Let's see what it is because understanding the skew will help us implement trading strategies with options.

[00:00:23.11] - Speaker 1
Let's start with the definition. In options trading, skew refers to the asymmetrical pattern of implied volatility across different strike prices or of option contracts with the same expiration date. We know that implied volatility is a measure of market expectations for future price movements of the underlying asset. The skew represents the difference in implied volatility between out of the money options at the money option and in the money options. Skew can be either positive or negative.

[00:00:49.06] - Speaker 1
Positive skew occurs when the implied volatility of out of the money options is higher than the one of the in the money options. This means the out of the money put options have higher implied volatility compared to the in the money call options. Positive skew is typically associated with a higher demand for downside protection or a perception of increased risk in the market. Negative skew, on the other hand, arises when the implied volatility of in the money options is higher than the out of the money options. In this case, in the money call options have higher implied volatility compared to out of the money put options.

[00:01:20.01] - Speaker 1
Negative skew is less common and often reflects a more optimistic market sentiment and an expectation of an upward price movement. Skew is very important for option traders because it can affect the premium and the success of a trading strategy. For example, if the skew is positive, an investor may prefer to buy put options rather than call options to take advantage of the higher downside volatility. At the beginning we talked about the difference between the SKU and the term structure. The two are often confused.

[00:01:46.20] - Speaker 1
Here we can see the term structure and here we can see the sku. The star represents a strike skew is the moneyness for that expiration. In this slide we see the typical shape of a sku. It is possible to find the SKU on different platforms or through your broker trading platform, e.g. tWS from Interactive Brokers.

[00:02:05.08] - Speaker 1
On the left you have the level of volatility while on the right you can see the moneyness. So this shows us how based on moneyness, volatility goes up or down. Let's now try to understand why the skew takes certain forms. In this example we see the skew of the SPX index, which is one of the most liquid assets and with the largest option volumes. In the red box we can see the at the money strikes on the left side we find the volatility of the downside.

[00:02:30.10] - Speaker 1
This means that that part of the skew goes up when there is a market crash. In general, in that part of the skew, investors are long out of the money puts and short in the money calls. In practice, investors buy puts for protection and go short calls to finance the cost of the premium of the puts on the right side of the skew. Instead, we find the volatility for the upside. That part of the skew follows a bull market.

[00:02:53.13] - Speaker 1
Typically, the investors in this part of the skew are long out of the money calls and short in the money puts to fund the premium of the long calls. The skew of indices such as the SPX tends to be higher on the left hand side as the market is willing to pay more for out of the money puts to protect from a crash. If we take an investment fund, it tends to be long risk assets. Because of this, the fund tends to buy puts for protection in case of crashes. This is one of the reasons why when there is a major event like the FOMC meeting of the Federal Reserve or the release of a macro data like the cpi, you see the left side of the skew increasing the demand for puts before the event drives up the volatility of those puts that cost more and more.

[00:03:33.06] - Speaker 1
One of the strategies used by investors is to sell calls to collect the premium and pay all or part of the cost of the puts. If the market crashes, the market maker wants to get paid more for the risk he's taking. More volatility means more risk for the market maker. Therefore, the skew goes up from the left hand side of the puts and the right side of the calls. In those cases, in tail events, risk is higher.

[00:03:55.01] - Speaker 1
Looking at the skew also helps us understand how it can increase the premium cost of our options. In this slide we can see how the skew moves. The more volatility on out of the money puts increases. So the three points that help us understand skew volatility, risk and leverage. Lets start with volatility.

[00:04:12.17] - Speaker 1
As we know at the money is the point where uncertainty is the highest. In fact, the skew tends to move after that point. However, volatility tends to increase the more we go down in the strikes because the market has greater demand for protection. More demand equals More volatility. And as we know, implied volatility looks at the future.

[00:04:30.13] - Speaker 1
We then have risk, but we already covered this part. And finally, the leverage. Leverage drives the market up faster, but also down. For this reason, the increase in leverage is also one of the reasons why the SKU takes different shapes. At this point we can look at different types of skew but also at different skus by asset class.

[00:04:48.15] - Speaker 1
Here we see the SKU called smile or volatility smile. A smile is a common form of skew that describes the relationship between the price of a call and a put option for a given underlying instrument. It looks like a tilted smile with the bottom side representing put option and the top side representing call options. The smile is tilted up and to the left, indicating that put options are more expensive than call options with the same strike. This is a more typical structure for forex and equity markets.

[00:05:16.20] - Speaker 1
We then have the skew smirk, which is a term used to describe a specific shape of the smile. It occurs when the relationship between the price of call and put options is less pronounced than in a standard smile. In these cases, the volatility on lower strikes tends to be higher than on higher strikes. This happens because investors worry more about a potential crash and tend to buy out of the money puts. Here we can see the movement of skew based on the increase in volatility.

[00:05:41.27] - Speaker 1
This part is very important. Skew tends to lower during normalized period. Volatility tends to stay higher on the left side where the sticky strikes are. So far we have talked about generic skews. Now we will talk about other types of skew.

[00:05:55.29] - Speaker 1
We will then show you how the skews change based on the asset class you follow. The 25 Delta skew refers to the relationship between the prices of call and put options with a delta of 25. These are therefore out of the money options. This skew is also known as risk reversal. If the 25 delta skew is positive, it means that call option with a delta of 25 are more expensive than put options with the same Delta.

[00:06:19.11] - Speaker 1
If the 25 delta skew is negative, it means the put option with the delta of 25 are more expensive than call options with the same delta. If the 25 delta skew is positive, a trader may prefer to buy put options rather than calls with the same delta to take advantage of lower price. The 25 delta skew can also be used to look at market perceptions of risk and implied volatility. We then have the horizontal skew, which refers to a smile shape that is flat or nearly Flat compared to the standard smile. In an horizontal skew, the implied volatility for both a call or a put options at different strikes is similar.

[00:06:52.25] - Speaker 1
Horizontal skew can occur when the market perceives little risk to a particular underlying asset as the volatility difference for the option with a different strike is small. In this situation, the implied volatility for a call and put option is relatively similar across all strikes. A trader may prefer to sell options when horizontal skew is present as the price difference between call and put option is small, making it difficult to profit from a large price movement. In contrast with horizontal skew, we have vertical skew. In a vertical skew, the implied volatility for a call and put option at different strikes is not similar.

[00:07:25.02] - Speaker 1
For example, if the vertical skew is positive, it means that the implied volatility for call options is higher than for put options at similar strikes. If the vertical skew is negative, it means that the implied volatility for put options is higher than for call options. At this point, we can talk about the shape of the skew for the different asset classes. Let's start with the skew for single stocks. During the meme trend of 2020, we saw the price of companies like GameStop skyrocketed.

[00:07:50.20] - Speaker 1
Driven by option volumes, single stocks tend to have a more aggressive skew than an index like the S&P 500. For example, if we look at the Forex market, we notice how the skew is like a smile. Volatility tends to be similar on both the downside and upside. This is due to the fact that we don't have crashes like the one in stocks that prompt us to buy puts. This is the oil skew.

[00:08:11.07] - Speaker 1
But why does it have this shape? Because when there is a crisis, the price tends to go up. For example, after the 2022 sanctions against Russia, the skew went sharply higher as the sanctions created a supply shock. This led to a decrease in oil supply, which drives the market higher. Because of this, the market tends to see volatility peaks on the right side of the skew.

[00:08:31.19] - Speaker 1
Gold also tends to have upside volatility on the right side. This is because investors buy gold when the stock market crashes. This means that the volatility of gold is higher on the upside and therefore on the right side of the skew. At this point, let's dig deeper into the difference between long or short skew. But what is the difference?

[00:08:50.07] - Speaker 1
Let's look at it in the next slide. When an investor is long skew, it means there is long volatility as we see in this example, the skew goes up when there is a period of stress in the market. Investors can then use long volatility strategies or go long options. In this slide, we show you the relationship of the skew with the price of an index such as the SPX index. Short skew instead is the opposite.

[00:09:14.00] - Speaker 1
In this case, the investor is short volatility. When the skew goes down, the market is normalizing. In these cases, investors can go short options or use spreads that benefit from low volatility. Again, we will talk about this in the practical section. Now here is another slide.

[00:09:30.17] - Speaker 1
But why do we call this slide vegatrade? Vega, if you remember, is the Greek that follows volatility. If we invest using skew, the strategy has vega exposure. It is in effect a volatility trade. If we create a spread using the skew, we have exposure to vega.

[00:09:46.16] - Speaker 1
In the next slide, we can see how the spread is created using the sku. In this example, an investor is long a put and short a call. What this means is that while volatility is long on the put side, it is short volatility on the call side. But what happens if the skew goes up on the left side due to market stress? Our position gains on the put side and also on the call side.

[00:10:08.20] - Speaker 1
In fact, the put acquires greater value thanks to the increase in volatility, while our short the call makes money thanks to the collapse of volatility of the call. This happens if all other Greeks stay the same. But what you can see is that the skew is a volatility play, a vega play. If we invest looking at the skew, we do it because we want to profit from the movement of volatility. We are coming to the end of the lesson on skew, but there is still a little left.

[00:10:34.19] - Speaker 1
One of the things we will cover here is the relationship between skew and the term structure. And we will briefly touch on the volatility surface. Let's do a quick recap. Skew helps us understand the risk direction based on investor perception. Our implied volatility can change based on asset movement and option volumes and the price of spreads such as call spreads and put spreads, etc.

[00:10:56.10] - Speaker 1
Now let's try to understand the relationship between the term structure and the skew. In this slide we see the term structure of the SPX index. When there is market stress, the short end of the term structure goes up. So the short term volatility in the term structure goes up. But what happens to the skew?

[00:11:12.05] - Speaker 1
We note in that case that in those short term expirations, the more the market price goes down and the short term structure goes up, the more the skew goes up from the left side. In that case, we see an increase in volatility on the put side. This drives up the skew and premium paid on those puts. So there are three reasons why the skew and the term structure are related. It is important to understand their relationship.

[00:11:34.10] - Speaker 1
During events such as bankruptcies or market crashes, these events make both move in the same direction. Then there is the implied volatility which becomes sticky the closer the price of the underlying approaches, the lower strikes. And finally the implied correlation. It is the first time we talked about this, but what is the implied correlation and why it is important? The implied correlation of an index is a measure of correlation between the members of an index.

[00:11:57.24] - Speaker 1
For example, the correlation between Tesla and Apple in the spx. In other words, implied correlation represents the degree of correlation that is implied by the prices in the option market. A high level of implied correlation indicates that index members are correlated with each other, while a low level indicates little or no correlation. Implied correlation can be used as an indicator of market expectations regarding risk diversification in indices. For example, during times of economic uncertainty, implied correlations tend to rise as investors expect companies in the index to perform.

[00:12:29.12] - Speaker 1
Similarly, this can have important implications for investors as it can affect their portfolio diversification and risk management. Finally, the last point of this the volatility surface. It is not a very common concept among retail investors, but it is a concept that can help us understand how institutional investors analyze volatility. This is the typical volatility surface which has three dimensions. The volatility surface is a graphical representation showing the relationship between the price of options and the implied volatility of the underlying stock.

[00:12:59.22] - Speaker 1
The volatility surface is created by plotting the implied volatility for different option expirations and for different strikes. The volatility surface has three dimensions. The first one is strike or minus. Then there is time to maturity and finally implied volatility. It's a very interesting tool which can very quickly help you visualize the three factors on a single graph.

[00:13:20.25] - Speaker 1
It is used very often by market makers to find discrepancies and arbitrage opportunity on the volatility service and for risk management purposes. In the next lesson we will talk about their risk.