you should familiarize yourself with how the smile typically changes with different volatilities.. use historic pricing on options to see how it changes with the different volatility assumptions.. its different of course in every security in every situation.. for what are you trading?
Does the volatility shape frequently to expiry or the shape generally remain with different volatility level? stk
It generally gets steeper (in index) as you approach expiration. Of course the x-delta risk-reversal vol% in puts(itm calls) will decline as the index rallies.
Actually, in root-time space the skew gets flatter. That is, if you are adjusting the slope by the square-root of time, it gets slightly flatter as it approaches maturity. This, of course, begs the question what is the best measure of skew and nobody could answer that (footnote 1) for a general case. In addition, trading the skew is a tricky business, caveat emptor, but there are a lot of opportunities. I have like 6 models of the skew and some 10 different trading strategies that I do. footnote 1. this question ranks right behind "how many pairs of shoes does a woman really need?"
Any chance you're willing to share some helpful readings, be it books or papers, that you found helpful on trading skew and creating models for it ?
OK, but I was referring to the deep stuff that is impacted by microstructure; stuff at 10x30 cents that implies a 40 offer on vol very close to exp. Send those trading strats when you have a moment.
i'd love to hear how some of you guys exploit the vol term structure.. square root of time... so thats like a time adjusted vol skew? meaning that if adjusted for time the volatility smile is actually flatter... would that imply that options that are out of the money at expiration have alot more gamma risk then the BSM model sugguests?
So let's say you're quoting the ask side at $0.30, being about 40 vol (above fair). You get filled as someone buys back their short, crossing the spread and lifting your offer. You're now short at 40 vol, ITM, close to expiry. How are you practically going to unwind that, without giving away your captured edge?