How to Trade Option Skew

Trading the option's skew is a profitable way for traders to take advantage of different implied volatility levels across time and for different strike prices. The knowledgeable trader can use the option's skew by purchasing options that have low implied volatility and selling options that have a higher implied volatility. Traders can trade either a price skew or a time skew. A price skew is a chart that displays implied volatility along the vertical axis and strike prices along the horizontal axis. A time skew shows implied volatility along the vertical axis and has different option expiration dates along the horizontal axis.

Decide if you want to trade based off a price skew or a time skew. Create implied volatility charts for both price and time and look for instances in which the difference among the various options implied volatility is the greatest. The greater the difference in the option's implied volatility the greater the potential for profit on the trade. Avoid option skews that appear flat on the chart, which would suggest that there is little difference among the various different implied volatility levels for the options you are evaluating.

Select an options combination trade to take advantage of the options skew you selected. For instance, if you selected to trade based off an option's price skew consider trading what is known as a vertical spread trade. This trade would require you to purchase an option with a lower implied volatility and sell an option with a higher implied volatility but with a different strike price that has the same expiration date as the option you purchased. If you chose to trade based on a time skew consider trading a horizontal spread sometimes referred to as calendar spread because it requires you purchase an option with a low implied volatility and sell an option with a higher implied volatility, yet both options should have the same strike price and different expiration dates.

Place your stock option combination order with your registered options broker.

Monitor your trade. Know at which point you want to exit the trade at a profit and at which point you want to exit the trade at a loss. Evaluate a profit graph that shows the possible outcomes of an options trading strategy. Profit or loss are graphed on the vertical axis while the underlying stock price on expiration date is graphed on the horizontal axis. Look at the profit graph for your trade and identify at what stock price the trade will be profitable and at what stock price your trade will produce a loss.

Warnings

  • Trading the options market is risky. Trade only with risk capital. Risk capital is the amount of money you will need to place on deposit in a brokerage account that if you were to lose as a result of your trading will not result in severe financial hardship.

References

About the Author

Pedro Carrasquillo began writing professionally in 2002 while working for the New Jersey state legislature. He coauthored the legislature's annual "Budget Analysis for the Department of Community Affairs" from 2002-07. Carrasquillo holds a Bachelor of Arts in comparative literature from Haverford College as well as a Master of Science in public policy and management from Carnegie Mellon University.