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