Today Tom Sosnoff and Tony Battista delve into individual strike prices to discover whether OTM puts or OTM calls trade with higher IVs and why. When there is upside skew (calls are more expensive than puts) what strategies can we implement?
Implied volatility (IV) is a topic that is often covered when talking about options trading concepts and strategies. In general, when we discuss IV, we are referring to the overall IV of an underlying. To get a better picture of the market’s expectations we can look at the IV specific to individual strike prices.
Under normal conditions in equities, we observe an IV skew to the downside. This means that the IV of out-of-the-money (OTM) puts is greater than the IV of OTM calls. Tom said, "That's the world's core position."
This is due to investors naturally being long stock, in which they can purchase puts to hedge and sell calls to improve the cost basis of their position. This natural purchasing of puts and selling of calls results in higher put prices and lower call prices, and subsequently higher IV for puts and lower IV for calls.
It’s important to note that this is generally true only for equities and not commodities. Tom explained, "In commodities there is a natural floor. A stock can theoretically go to zero but can a commodity go to zero? Crude Oil is not going to zero. Corn and Wheat are not going to zero."
Now, in some instances this relationship inverts, where the prices and IVs of OTM calls are greater than the OTM puts. This is known as upside or reverse skew.
A recent occurrence of this happened in FXI, the Chinese Large-Cap ETF. The stock traded in a $40.00-$44.00 range for 3 months before exploding to the $52.00 area. Tom added, "This is when the world got scared that Chinese stocks may explode." We can see the change in the volatility of the options before and after the 25% upside move in FXI. Note the overall increase in option prices (implied volatility), with call prices increasing faster than put prices (resulting in a volatility curve with upside skew).
Some strategies that we employ in stocks with upside skew are:
1) Short Call
2) Covered Call
3) Reverse Jade Lizard (Short Call + Short Put Spread)
4) Ratio Iron Condors (Selling More Call Spreads Than Put)
5) Risk Reversal (Short Call + Long Put)
6) Collar (Short Call + Long Put + Long Stock)
Takeaways:
Due to the nature of the stock market, OTM puts generally trade with higher IVs than OTM calls
Sometimes, OTM calls trade with higher IVs than OTM puts (generally after quick and sizeable moves to the upside)
The skew can help you determine where the market is pricing the risk
Tom mentioned that over the course of the last year we have seen this upside skew in EWZ, TWTR, AAPL, FXI and GPRO. Tom said, "When puts are expensive relative to calls, we like to sell puts. When calls are expensive relative to puts, we like to sell calls. We are not that concerned on the underlying or why it's happening. We're not market making, we're just playing the counterparty role."
Join Tom Sosnoff and Tony Battista in this Market Measures segment to hear their insights!
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