How to Use the Volatility Skew | Market Chameleon

Introduction

This tutorial will guide you through understanding and using the volatility skew in options trading, as explained in the Market Chameleon video. The volatility skew reveals the difference in implied volatility between out-of-the-money, at-the-money, and in-the-money options. Knowing how to analyze this skew can provide insights into market sentiment and help you make informed trading decisions.

Step 1: Understand Implied Volatility

• Definition: Implied volatility (IV) measures the market's expectation of future price fluctuations of an asset.
• Skew Analysis: The volatility skew indicates how IV varies with different strike prices.
  • Out-of-the-money options typically have higher implied volatility.
  • In-the-money options usually have lower implied volatility.

Step 2: Assess Market Sentiment

• Call vs. Put Preferences: Analyze the skew to determine whether fund managers prefer to write calls or puts.
  • A higher IV in out-of-the-money puts may indicate bearish sentiment.
  • Conversely, higher IV in out-of-the-money calls might suggest bullish sentiment.

Step 3: Use the Black-Scholes Model

• Pricing Options: Familiarize yourself with the Black-Scholes model to price options and understand their implied volatility.
• Assumptions: The model assumes:
  • A normal distribution of returns
  • Equal probability of price moving up or down (50/50 chance)

Step 4: Analyze Price Movements

• Example: If a stock is at $279, it may move to $284 (up $5) or $274 (down $5).
  • Use the straddle price to find the expected movement range for options pricing.
• Calculating Volatility:
  • Volatility increases as you move away from the at-the-money strike.
  • Compare the implied volatility for nearby strikes to identify potential trading edges.

Step 5: Execute a Risk Reversal Strategy

• Concept: A risk reversal involves selling an overvalued option and buying an undervalued one.
  • Example Scenario:
    • Sell an out-of-the-money put and buy an out-of-the-money call.
    • Aim for a net credit from the transaction.
• Risk Management: Understand potential outcomes:
  • If the stock moves down, calculate losses on the put.
  • If it moves up, assess gains from the call, including net credits received.

Step 6: Identify Hard-to-Borrow Stocks

• Definition: Hard-to-borrow stocks are those that are difficult to short due to low availability.
• Impact on Strategy: When shorting is challenging, options pricing may not align with traditional arbitrage assumptions.

Conclusion

By understanding volatility skew and its implications on option pricing, you can gain valuable insights into market sentiment and enhance your trading strategies. Start by analyzing implied volatility, assess market sentiment, and explore options strategies like risk reversals. Always conduct thorough research before making trading decisions, and consider market conditions that may affect your strategies.