How to Profit from Volatility Skew Trading Strategies

The implied volatility in the options market has the potential to change the trading strategy, and options trading offers various strategies using which you can make a profit.

First, let us understand what volatility skew is. Then we shall move forward in learning the option strategies used in such markets. The difference in the implied volatility between out-of-the-money options, at-the-money options, and in-the-money options is presented in graphical form and is known as volatility skew. The volatility skew is created when the sentiments of the investors regarding the supply and demand of the options in the market change; it will also give us a brief idea of whether managers will write the call options or put options. The volatility 'smile' diagram is created when the strike prices of both call and put options go far from the current strike price.

The Volatility Skew is presented in graphical form. It shows the implied volatility of a specific set of options. In the volatility skew, the options have the same expiry and strike price, and sometimes only the strike price is different. When the graph seems more balanced, it creates a smile-like structure, and when it is weighted more on one side, it creates a smirk-like structure.

As we all know, many options traders base their trading strategies on various implied volatility levels. The options market has many strategies that can avail profit to traders even in volatile times.

We shall see one such strategy on this page, known as put ratio spread. When you apply the opposite things from the put ratio spread, it becomes call ratio spreads.

Understanding the Reverse Skew:

When the implied volatility on the lower options strike price is higher, the skew made by plotting them on the graph is a reverse skew. This skew is generally created when the traders are concerned about the market conditions and the risk associated with their position. To avoid that, they buy the put options for compensating the risk. You will find this reverse skew in the long-term options or indexes.

Understanding the forward skew:

When the implied volatility on the higher options strike price is higher, the skew made by plotting them on the graph is a forward skew. This type of skew is observed in the commodities market more, as the imbalance in the demand and supply in the market can drive the price up or down. The commodities included are oil, agricultural products, etc. they majorly create the forward skew.

How do you use the ratio spread options strategy to make a profit?

Let's find out the answer to the above question. First, understand there are five major factors that affect the price of the options: the market price of the underlying asset, strike price, time left to expire, Interest rate, and Implied Volatility.

Traders need to buy the options with low implied volatility and sell the ones with high implied volatility. By offsetting the sales of the options contract by 2:1 to the options you bought, you can profit from the negative skew created by put options.

Traders must use technical analysis to make better entries in the volatile market. Another important thing a trader must note here is to make an ideal exit strategy that also gives a handsome profit.

Example of Volatility Skew Trading:

Suppose the stocks of ABC are trading at Rs. 120 in April. You are looking at the June Option chain and found the following put option prices:

ABC 100 June Put 20

ABC 110 June Put 24

ABC 120 June Put 36

ABC 130 June Put 44

ABC 140 June Put 54

Calculate the Implied volatility for all the above strike prices, and you get the following.

ABC 100 June Put 15

ABC 110 June Put 10

ABC 120 June Put 8

ABC 130 June Put 10

ABC 140 June Put 15

As we can see, the implied volatility of every strike price is different. The reason behind this difference is the forces of market demand and supply. You can see some of the options with specific strike prices are in more demand than others. When plotted on the graph, the above IV will make a volatility smile.

If the implied volatility is higher out-of-the-money, then the shape of the curve would be tilted more on one side, creating the smirk. Smirk is often created when traders expect a fall in the stock price.

Traders have some other strategies, too, to handle the volatility skew in the stock market, such as Out-of-the-money Bull put spread and Out-of-the-money Put calendar spread.

So lastly, the ratio spread options strategy is quite different from that of a credit spread. A trader has equal short and long contracts in the credit spread strategy. Thus, the volatility risk and the skew are minimal, and the direction plays a major role. It would help if you considered the ratio spread strategy in your list of strategies to get the profit.