8. Volatility Skewing

Distilling concepts to their essence can clear up misconceptions and facilitate wise decision-making. Such is the case with the concept of "volatility skewing."

Volatility skewing refers to the situation in some commodity options where different strike prices trade at different implied volatility levels.

A "positive skew" describes commodities like the grains and metals. In these markets, out of the money calls are perpetually overpriced and out of the money puts are perpetually underpriced.

A "negative skew" describes commodities like the S&P500 where out of the money calls trade at a lower implied volatility than out of the money puts. This means, out of the money calls are perpetually underpriced and out of the money puts are perpetually overpriced.

Volatility skewing sets up situations for explosive profits. How? In two ways:

1. By initiating CALL ratio backspreads in markets having a negative skew. If the market rallies, the position earns money not only because it gets progressively longer in deltas, but also because the multiple long calls trade at progressively higher levels of implied volatility to "supercharge" profits.

2. By initiating PUT ratio backspreads in markets having a positive skew. If the market declines, the position earns money not only because it gets progressively shorter in deltas, but also because the multiple long puts trade at progressively higher levels of implied volatility.

Some market analysts look at the "flip side" and say you also gain a theoretical advantage by initiating put ratio spreads in negative skew markets and call ratio spreads in positive skew markets. I disagree for two reasons:

• The skew is a constant phenomena, so it's an illusion to think there's a theoretical advantage of selling higher implied volatility options as compared to the one being purchased as part of the ratio spread, and

• The holder of a put ratio spread in a negative skew market must contend with open-ended losses if the market declines sharply. Likewise, the holder of a call ratio spread in a positive skew market can incur open-ended losses if the market rallies quickly.
  

"Knowledge is power and all traders can benefit by continually bolstering their knowledge base. I hope to contribute in that regard."  Paul Forchione