Steve Meizinger

Learn About Volatility

through
Options Skew
For the sake of simplicity, the examples that follow do not take into
consideration commissions and other transaction fees, tax considerations, or
margin requirements, which are factors that may significantly affect the
economic consequences of a given strategy. An investor should review
transaction costs, margin requirements and tax considerations with a broker
and tax advisor before entering into any options transaction.

Options involve risk and are not suitable for everyone. Prior to buying or
selling an option, a person must receive a copy of CHARACTERISTICS AND
RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you
today and may be obtained from your broker, one of the exchanges or The
Options Clearing Corporation. A prospectus, which discusses the role of The
Options Clearing Corporation, is also available, without charge, upon request
at 1-888-OPTIONS or www.optionseducation.org .

Any strategies discussed, including examples using actual securities

price data, are strictly for illustrative and educational purposes and are not to
be construed as an endorsement, recommendation or solicitation to buy or sell
securities.

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Options Create Opportunities
Bearish Moderately Neutral Moderately Bullish
Bearish Bullish
1) Buy put 1) Sell call 1) Sell 1) Covered 1) Buy call
2) Buy put strangle write (sell 2) Buy
(bear) 2) Sell put) underlying
spread, sell straddle 2) Buy call purchase
call spread 3) Buy (bull) protective
3) Buy ratio strangle spread, sell put
put spread 4) Buy put spread
straddle 3) Buy ratio
5) Buy call spread
butterfly
6) Buy
calendar
spread
7) Sell
calendar
spread

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Market Strategies

• Most market strategies are based on one of three

characteristics
– Yield based
– Trend-following
– Trend-reversion

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Theory behind options

• Theoretical foundations laid by the German mathematician,

Gauss, as “Gausschen normal distribution” works on the
principle that coincidental values fluctuate around a middle value
in the shape of a bell curve (log normal distribution). The
economists, Markowitz, Black & Scholes and Sharpe expanded
on this in their formulae of portfolio theory and option price
calculation

• Fluctuating around the middle value is portrayed as a standard

deviation/variance and, calculated on a yearly basis, is described
as volatility

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Option Prices are Based on Probabilities

Options pricing is based on risk neutrality, theory states

that assets will likely revert back to a mean price

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Theory of reversion to the mean

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Models prefer simplicity

• The options theory assumes constant volatilities for different

options

• Bell curve simply means that things revert to the mean in the
long run. Also, as you deviate further and further away from the
mean, the probability of that deviation will drop faster and faster.
Therefore, by the definition of the Bell curve, extreme deviation
from the mean is extremely unlikely.

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Reality is different

• Assumptions that may not be true:

– Markets are efficiently priced, no pricing gaps from one
moment to the next
– Returns are log-normally distributed
– Borrow and lend at one risk-free rate
– Dividends are fully predictable
– No restrictions on short-selling
– No arbitrage opportunities
– No early exercise

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Conceptually all options are priced at the at the same implied volatility

• A flat smile or no skew gives you a log-normal return

distribution which is exactly what is used in Black-
Scholes.

• When the smile/skew is above the flat line there is

more weight given to that outcome relative to the log-
normal distribution

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Options smile theory

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Skew

• The term options skew has various meanings, let’s

refer to skew as a variance from the normal implied
volatility

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Skew

• It can be extremely difficult to ascertain the true

distribution of an extremely negatively (sometimes
positively) skewed forecast from historical data

• When it is below less weight is given. Therefore the

smile creates “Fat tails”

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Equity options often exhibit skew

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EUU

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Unexpected events can occur though

• An example of extreme movement, EUR/USD using a June 7

implied volatility, the expected monthly move can be calculated
as follows 17 vol/ square root of 12 (4.91)
• Since May 7 the euro/usd has moved approximately $8.21, about
11/2 standard deviations in one month’s time

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Why do equities exhibit skew?

• Leverage
– As assets fall in price the price of insuring the fall increases,
assets tend to fall faster than they rise
– Financial leverage- Weakened balance sheets mean more
equity risk and potential rewards

• Simply put, more demand relative to supply

– Downside- More OTM put buyers and call sellers
– The risk of “blowing up to the downside”
– Upside- More OTM call buyers
– The risk of “blowing up to the upside”

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Vertical and horizontal skew

• Strike skew refers to the different volatilities for the

various strike prices (smile)
• Time skew refers to the different volatilities for the
various months
• Time skew normally occurs when the marketplace
expects an extraordinary event to occur in a particular
month

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How can you use skew?

• Skew can be used in many ways when trading

spreads
– You can choose to trade against the skew, buying the
“cheaper” option and selling the more “expensive”
– OR, you can choose to trade with the skew, buying the
“expensive” option and selling the “cheaper” option
• Cheap or expensive are terms that must be
determined by each trader based on your view of the
markets

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Skew scenarios

• Options supply and demand considerations create the

perception of “cheap” or “expensive”

• Ultimately each investor must decide if options are

“cheap” or “expensive” based on their own risk/reward
tolerances.

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Skew

• Skew is typically most pronounced for OTM options,

but ATM option can exhibit skew, especially during
quiet market periods

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Let’s review some skew charts

• The live vol skew charts can help you understand how
the marketplace reacts to changing news
• All skew charts made available by www.livevol.com

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SPY and time and strike skew

Monthly skew legend: Red- 1st month Light Blue- 4th month
Yellow- 2nd month Dark Blue- 5th month
Green- 3rd month Purple- 6th month
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SPY and time and strike skew

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SPY and time and strike skew

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SPY and time and strike skew

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July skew

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Current SPY skew

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GS day prior to SEC announcement

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GS day of SEC announcement

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GS

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GS

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July GS

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Current GS

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GLD

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GLD

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GLD

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July GLD

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Current GLD

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BIDU

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BIDU

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BIDU

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BIDU

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July BIDU

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Current BIDU

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RMBS

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RMBS

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RMBS

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RMBS

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July RMBS

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Current RMBS

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ITMN

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ITMN

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ITMN

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ITMN

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July ITMN

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Current ITMN

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GIS

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GIS

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GIS

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GIS

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July GIS

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Current GIS

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EUU

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EUU

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EUU

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EUU

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July EUU

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Current EUU

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Examples using USD/EUR implied volatilities (June)
1st leg 2nd leg Components Explanation

1-2 mo call 19 volatility 17 volatility Long 2nd short Against the

calendar 1st calendar skew
1-2 mo put 19 volatility 17 volatility Long 2nd short Against the
calendar 1st calendar skew
1 mo 117/121 20 volatility 18 volatility Long lower With the skew
c vertical short higher
vertical
1 mo 20 volatility 18 volatility Long lower Against the
117/121p short higher skew
vertical vertical

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Current Aug 2010 EUU skews
1st leg 2nd leg Components Explanation

1-2 mo call 11 volatility 11 volatility Long 2nd short No skew

calendar 1st calendar
1-2 mo put 11 volatility 11 volatility Long 2nd short No skew
calendar 1st calendar
1 mo 11 volatility 11 volatility Long lower No skew
131/134c short higher
vertical
1 mo 11 volatility 11 volatility Long lower No skew
134/131p short higher
vertical

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Calendars, verticals and skew
Negative Positive Negative time Positive time
Strike skew Strike skew skew skew
Higher volatility Higher Higher Higher
as prices drop volatility as volatility in volatility in the
prices rise shorter-term longer-term
Long Against skew With skew
calendar
Short With skew Against skew
calendar
Long vertical With the skew Against the
call spread skew
Long vertical Against skew With skew
put spread
Short vertical Against skew With skew
call spread
Short vertical With skew Against skew
put spread
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Flexibility is key

• Adjusting to the various market conditions and finding

investment strategies that meet your own financial
goals and risk tolerances are very important for all
investors

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Summary

• Option volatility is measured in many ways

• Implied volatility measures the inferred volatility that

comes from the actual market price using a standard
option pricing model

• Each strike price will trade at various implied

volatilities based on supply and demand

• Occasionally the implied volatilities might differ greatly

based on differing expectations by the marketplace

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Summary

• The term “skew” defines the difference between an expected

normal options price value and the market price

• Skew is most pronounced when most participants are predicting

the potential for large asymmetric move

• Traders should consider the skew implications, time or strike

skew, prior to entering any options transaction

• If the risk/reward does not seem rewarding, consider an

alternative trading situation

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www.fxoptions.com

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Steve Meizinger
[email protected]
www.ise.com