trading skew

Discussion in 'Options' started by johntsai90, Nov 18, 2009.

  1. when people said trading skews? What do they really mean?

    is that something to do with richness/cheapness of each strike comparing call and put?
     
  2. Draw a graph of implied vol of options vs their strike/moneyness/delta. Simplistically, trading the skew involves expressing a view on the shape of the graph.
     
  3. Will the "smile" turn into a smirk, grin or a frown? That is the "question". :cool:
     
  4. martinghoul and nazzdack have a diverse way of saying the same thing.
     
  5. nO0b

    nO0b

    after the crash of 1987, markets began to realize that "hey, stock prices can crash" and began to value OTM puts very differently than what black-scholes and common pricing models would have predicted based solely on the observed volatility of the underlying stock.

    Market-makers now faced a risk that panic-selling on a stock would leave them short puts sold for very little premium when they were OTM, which suddenly became very, very ITM.

    Models fitting the entire volatility curve now needed to account for this added notional risk for OTM options (fear of a crash in the case of OTM puts, and wild optimism in the case of OTM calls) and the "volatility smile" was born.

    Typically, this added parameter to the model was called the "skew". The value of which is directly related to how far OTM the option is.

    A modern example of how skew is "bought" and "sold" might be a biotech firm. biotech's are often very bimodal, which means they can go bankrupt trying to cure cancer, or they can actually *cure* cancer and become a $100k stock overnight.

    A person might want to bet that a biotech is soon going bankrupt, and its stock will be worthless within a year. Such a trader would be looking to buy cheap OTM puts because he believes they will soon be deeply ITM and can be exercised for huge profit.

    So he would be willing to pay more than a typical model would predict they were worth (using the volatility of the underlying as an input) because these $0.05 puts will soon be worth many times that amount. He might also buy puts on higher strikes but would be willing to pay less and less of a premium as his risk/reward ratio begins to flatten. So a predictive model needs to realize that as a percentage, this strange new premium he's paying is a greater component of the price, as you venture further and further OTM.

    In that sense, he's bidding up this additional extrinsic parameter called "skew". He becomes a *buyer* of the put skew, since he believes its under-valued, given his outlook.

    Similarly, he would gladly sell OTM calls, since the stock (he believes) will never go up high enough for those calls to become ITM, leaving him at risk for assignment. So he's is a *seller* of call skew, since those suckers who think this company is going to cure cancer are bidding up the calls to levels that black-scholes would not have predicted.

    Basically, skew is just another piece of extrinsic risk in an option price, driven almost exclusively by fear and greed. :D
     
  6. any options model you care to use will not give you accurate pricing on far out of the money options. ( Taleb, Mandelbrot..even Wilmott)

    ...100 year floods.....black swans....whatever you want to call it, happens with alarming regularity.

    my motto is simply: never sell the wings. Maybe they are too expensive to buy ..but I'll never sell them. ( in significant quanties anyway.)
     
  7. They happen every 10 years. :cool:
     
  8. EdgeAnalytix.net

    EdgeAnalytix.net Vendor

    ...100 year floods.....black swans....whatever you want to call it, happens with alarming regularity.

    my motto is simply: never sell the wings. Maybe they are too expensive to buy ..but I'll never sell them. ( in significant quanties anyway.) [/B][/QUOTE].

    This motto pretty much captures the essence of what do to to ensure trading longevity especially when it comes to trading skew. Never oversell the wings.
     
  9. jim c

    jim c

    Great explanation. My question is why do we see this same skewing in the interest rates products...eurodollars or the ten year? Thanks alot. Jim
     
  10. 1) Financial commodities; i.e. stocks, bonds and currencies tend to "panic" to the downside. People can be desperate to buy put-options. They also tend to have active covered-call writing which "depresses" call option values.
    2) Physical commodities; i.e. grains, metals and energies tend to "panic" to the upside. People can be desperate to buy call-options. That gives "steepness" to the skew for those options. :cool:
     
    #10     Nov 20, 2009