Few things. a) volatility skew (a.k.a smile, smirk) is the structure of volatility across strikes for a given expiry date. For example, if you look at Jun Bund, 20 delta put is trading at 4.29% price vol, while 20 delta call is trading at 4.00%, the differential is due to the volatility skew. In general, it's worth separating the "skew" as slope of the vols accross the strikes and the "smile", which is the differential between ATM vols and the OTM vols. On shorter expiries, skew in general shows the bias of the underlying (like, in case of bund, the skew is suggesting a selloff bias), while on longer expiries,the skew suggest the correlation of volatility to the underlying. Smile, on the other hand, suggests the implied gap risk and the general propensity of people for buying wings. Actually, to scalp gamma, you want to buy straddles. This way, as the market rallies, you selling and locking in profit and as the market sells off, you are buying a locking in profit. If you are short straddle, every time you rebalance your delta you are locking in a loss.
So, if I want to take advantage of the skew, I could - short naked puts - short put ratio spreads. Any other (safer) suggestions than these two?
Not to be a smarta$$, but you say "skew" is the slope across strikes and "smile" is the difference between ATM and OTM. How's that different from each other!? ATM/OTM is determined by the strikes.
To come back to the original question. What's a skew trade? As in previous replies stated there are different IV's for different strikes and also different between months. If a trader buys one option and sells another while also trading an amount of underlying to delta hedge the combination one made a skew trade. One assumes that the option one sells has a relatively high IV compared to another. If one trades this combination naked I wouldn't call it a skew trade but just a positional trade. Professional Market Makers and derivatives traders are doing skew trades (the way I described) all day. I use to be a Market Maker/derivatives trader in stock options and was doing this all day. Just see which I could sell and if so which one to buy in return.
You can have a difference between ATM and the wings without any slope across the strike. In that case, price of a risk reversal in vol terms will be 0, while price of a strangle will show you the smile. Alternatively, you could envision an example where a risk reversal will be high, but the price of a strangle would be as if it's priced with ATM vol. BTW, you are a smarta$$, that's why we all love you. So, to answer the original question - a pure skew trade is a trade where one takes an overall vega neutral position on wings vs ATM or wing vs wing. For example, a risk-reversal (long OTM put, short OTM call), or a vega-neutral fly. ps. back to my admin shit
It seems that most posts on this thread start from the assumption that a retail trader could find and profit of mispriced options, on a systematic basis. In my (and others') opinion markets price all the available information in the asset's price. I.e. the IV skew smile prices in the probability of outlier events; when a near expiration option has a higher IV than a further expiration one there is an event that justifies it, and so on. Considering slippage and commissions is highly unlikely that a retail options trader will be able to benefit on a regular basis from mispriced options (skewed implied volatility). There are bigger players with better tools that do it. If interested in this subject, search and browse through ET's forums because it was extensively discussed and argued. This will be good both for your education and ET's click count. I know that many books, including McMillan's options' Bible talk about skews and recommend strategies of benefiting from them. This doesn't mean that they're necessarily correct. They're just that author's point of view at the time of his book writing.
cnms, don't you know the options market is just a mine field of wrong pricing, waiting for Mr. Newtrader to come along and benefit from? Sell overpriced options ,buy underpriced ones. Candy.