Beware of the Skew

One of the most misused terms in retail options education is "volatility skew." Hence, we thought this would be a great opportunity to properly define and explain the term, writes Alex Mendoza of OptionABC.com.

What is Skew?
Implied volatility skew refers to the observation that not all options trade at the same volatility level even if they pertain to the same stock. This presents a problem for option traders due to the need to come up with one volatility level in order to calculate important numbers such as a stock's expected range. To make matters worse, there are two types of skew that traders must understand, vertical skew and time skew.

What is Vertical Skew?
Vertical skew is the difference in implied volatility levels between options in the same month. For example, if we consider the XYZ March 160/165 call spread, the vertical skew would refer to the difference in the implied volatility levels between the 160 call and the 165 call. To illustrate, consider the following example looking only at call options:

Note that the 160 calls have an implied volatility level of 17.41%, while the 165 calls have a level of 15.33%. That said, there are several ways to measure this skew.

Skew Measurement Method 1 - Percentage Difference

This is the simplest way to measure skew and usually the only way mentioned in retail education. As with any measurement, at times it can be useful and at times it can be downright reckless. Here's how it works:

Percentage Skew = (Higher Volatility Level - Lower Volatility Level) / (Lower Volatility Level)

In this example, our skew amount equals (17.41 - 15.33) / (15.33) = 13.57%

While this is the simplest of methods, it rarely tells us anything about the relationship between the options. A more common measurement among professionals bases itself on the actual dollar amount of skew priced into the options. Let's assume that the option vega for both the 160 and the 165 calls is 15 cents. Then, to calculate the dollar skew, we progress in the following manner:

Dollar Skew = (Higher Volatility Level - Lower Volatility Level) * Option Vega

In this example, our skew amount equals (17.41 - 15.33) * (.15) = $0.31

This is a far more useful calculation as it gives us an idea of just how much the option values differ as compared to a no-skew scenario.

NEXT PAGE: What is Time Skew?

Since we like to compare apples to apples as often as possible, we typically say that the options are trading at "31 cents of skew per $5.00 vertical." This simply refers to the amount of dollar skew based on the difference between the strikes, which in this particular example is $5.00. Traders tend to keep a record of the skew to see if it changes over time, since vertical skew tends to hold its value fairly well. This is in sharp contrast to time skew, which is not as important a measurement.

What is Time Skew?
Time skew refers to the difference in implied volatility levels over different expiration months. To illustrate, refer to the table below:

Retail traders get really excited about time skew, usually for the wrong reasons. It is usually calculated in percentage terms and is a fairly useless calculation as the reason for the existence of the skew is far more important than the actual skew value. Nevertheless, in an effort to be consistent, here is how we calculate the skew value:

Percentage Time Skew = (Far Month Vol. Level - Near Month Vol. Level) / (Near Month Vol. Level)

In this example, our skew amount equals (15.33 - 17.32) / (15.33) = - 13%

What retail traders tend to get excited about is a high and positive time skew level. That is, when the front month implied volatility is dramatically higher than that of the back month. Of course, a typical uninformed retail trader will then try to buy options in the month with lower implied volatility and sell options in the month with higher implied volatility. Buying a calendar spread in a high skew environment is one of the more reckless things a retail trader can do.

When a trader sees a high time skew, what it actually means is that implied volatility is high across the board. Usually this is a temporary and event-driven phenomenon. It tends to imply that the market is bracing itself for a large upcoming move-hardly the time to initiate range-bound trades like calendar spreads.

In a high time skew environment, buying a time spread typically does not generate additional money even if the volatilities revert back to their pre-skew level! Unfortunately, few traders heed this piece of advice, and most wait until they experience a very expensive trading lesson prior to revising their trading approach.

By Alex Mendoza, Founder, OptionABC.com