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Best Practices

Volatility Skew

May 23, 2016

Stock market indices and the ETFs that match them fall faster than they rise. The market is more likely to experience a meltdown than a melt up. This creates a higher demand for puts than calls. The implied volatility (IV) of the puts is therefore higher than the calls. We refer to this as Volatility Skew. This was demonstrated with a table comparing the IV of puts and calls in the SPY (S&P 500 ETF).

This is not the norm for many equities and ETFs based upon commodities. The market is currently pricing in a greater probability of a rise in the Gold ETF, GLD than a fall. GLD currently has inverse skew. Stocks fall faster than they rise and Gold rises faster than it falls. That is the driving reason behind their skews. Tom and Tony noted that once you understand where the perceived risk (where everybody's fears lie), that is when you can search for the opportunities.

Different strategies can take advantage of regular skew and inverse skew. The regular skew strategy list included Short Puts , Credit Vertical Call Spreads, Put Ratio Spreads, Jade Lizards and Big Lizards. The inverse skew strategy list include Naked Calls, Call Ratio Spreads, Reverse Jade Lizard and Reverse Big Lizard. An example comparing a SPY Big Lizard to a SPY reverse Big Lizard using regular skew with the SPY trading at $205 was displayed. The example showed that the Big Lizard is favorable in regular skew because a trader can widen the call spread which increases the probability of profit (POP) and generates a higher credit. An example comparing a GLD Put Ratio Spread to a GLD Call Ratio Spread using reverse skew and with GLD trading at $119.50 was displayed. The example showed that Call Ratio Spreads benefit from reverse skew because the further out-of-the-money Call trades richer than the further OTM put.

For more on Volatility Skew see:

Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of volatility skew, both the regular and inverse, and how to employ different strategies to each with a great cheat sheet that lists the strategies to use on each.

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