The terms Skew and IV tend to be used often in the options trading market so in today's PowerKnowledge, we explain what skew is and how it's used when trading options.
Skew refers to Volatility, or IV. In the option world the price of your option changes as IV changes, the amount your option changes is measured using a Greek called Vega.
Remember, if you have a positive Vega, for every 1% IV moves up your option will gain the current amount of Vega, and if it decreases by 1% your option value will decrease by your Vega.
- Option Value = $1
- Vega = $.05
IV increased by 1% so the new option value would be $1.05.
Let's take a look at a strike ladder example. Each Option, both Calls and Puts have IV associated with them. Remember IV is a large part of the options value, so if IV is high the corresponding option will be “rich” or expensive:
Skew is simply an easy way to look at IV and tells us whether Calls are more expensive than Puts compared to the ATM strikes. On the right side of the ATM are Call IV’s and on the left side are Put IV’s.
If options are expensive when IV is high we can somewhat deduce that option buyers are willing to pay a premium for either those Calls or Puts. If the right side, Calls, are higher than the left we know option buyers are bullish (probably).
If the left side is higher than the right, we know Puts are going bid, meaning traders are bearish.
Volatility is mean reverting and we can use that knowledge to gain an edge and trade the skew using something called a risk reversal. This is where you sell the “rich” option and buy the “cheap” option.
Understanding skew and IV is just another useful metric to get an idea of market conditions.
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