Skew Trading

Skew trading focuses on the relative pricing of options at different strikes rather than the overall level of volatility. A skew trader asks: are out of the money puts too expensive compared with calls? Is the curve too steep or too flat compared with history and with likely future moves? Trades are built to profit if the skew steepens or flattens, usually with limited exposure to the general level of volatility and to direction.

Measuring skew#

Traders compare current skew with its history, with realised behaviour (how often large down moves actually happened) and with other markets.

What drives skew#

• Demand for protection: more hedging demand steepens put skew.
• Supply from overwriting: covered call selling cheapens upside calls. See Covered Call.
• Market moves: skew usually steepens as markets fall and volatility rises, though in very sharp crashes at the money volatility can jump so much that measured skew flattens.
• Events and takeovers: single stocks with takeover potential may see call skew rise.
• Commodity supply shocks: upside call skew in oil or grains when supply is threatened.

The main skew trades#

Risk reversal#

Buy an out of the money call and sell an out of the money put (or the reverse), both delta hedged. See Synthetic Positions.

Put spreads and ratio spreads#

• Buying a put spread (long higher strike, short lower strike) sells the expensive far put to finance a nearer one. See Bear Put Spread.
• Put ratio spreads sell more far out of the money puts than they buy, harvesting steep skew with crash risk. See Ratio Spreads.
• Put backspreads buy more far puts than they sell, betting skew will steepen and crashes are underpriced.

Butterflies and wings#

Trades on curvature: buying or selling the wings (far strikes on both sides) against the at the money option, often expressed through the 25 delta butterfly.

Skew and direction#

Skew trades rarely remain direction neutral. As the underlying moves, strikes move closer to or further from the money, and deltas and vegas change. Short skew positions resemble short crash insurance and lose when markets fall quickly. Hedging delta frequently and modelling how the smile moves with price are essential. See Volatility Surface Dynamics.

Skew across markets#

Risks#

• Tail events: short skew can lose many times its expected profit in a crash.
• Model risk: measured skew depends on the volatility model and interpolation.
• Liquidity: far out of the money options can have wide spreads.
• Dynamics: skew can stay extreme for long periods.

Frequently asked questions#

What is skew trading?#

Trading the relative implied volatility of options at different strikes, aiming to profit if the skew steepens or flattens.

What is a risk reversal trade?#

Buying an out of the money call and selling an out of the money put, or vice versa, often delta hedged, to take a view on skew.

Why is index put skew so steep?#

Because of strong demand for crash protection, the tendency of volatility to rise when markets fall and the memory of past crashes such as 1987.

Next, trade the time dimension in Term Structure Trading.