Trading Skew
There are some trading strategies for which market makers have a natural
propensity that stems from their daily activity of maintaining their
positions. While money managers who manage equity funds get to know
the fundamentals of the stocks they trade very well, options market makers
know the volatility of the option classes they trade. When they adjust their
markets in reacting to order flow, it’s, mechanically, implied volatility that
they are raising or lowering to change theoretical values. They watch this
figure very carefully and trade its subtle changes.
A characteristic of options that many market makers and some other
active professional traders observe and trade is the volatility skew. Savvy
traders watch the implied volatility of the strikes above the at-the-money
(ATM)—referred to as calls , for simplicity—compared with the strikes
below the ATM, referred to as puts . In most stocks, there typically exists a
“normal” volatility skew inherent to options on that stock. When this skew
gets out of line, there may be an opportunity.
Say for a particular option class, the call that is 10 percent OTM typically
trades about four volatility points lower than the put that is 10 percent
OTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and
the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher,
say, nine points above where the calls are offered—for instance, the puts are
bid at 32 volatility bid while the calls are offered at 23 vol—a trader can
speculate on the skew reverting back to its normal relationship by selling
the puts, buying the calls, and hedging the delta by selling the right amount
of stock.
This position—long a call, short a put with a different strike, and short
stock on a delta-neutral ratio—is called a risk reversal. The motive for risk
reversals is to capture vega as the skew realigns itself. But there are many
risk factors that require careful attention.
First, as in other positions consisting of both long and short strikes, the
gamma, theta, and vega of the position will vary from positive to negative
depending on the price of the underlying. Risk-reversal traders must be