What is volatility skew?
Volatility skew is the difference in the implied volatility between out of the money calls and out of the money puts. Typically implied volatilities across different strikes exhibits what traders refer to as a "smile", i.e. out of the money options have slightly higher volatilities than at the money options. But sometimes the "smile" is "skewed", i.e. equally out of the money calls and puts differ in their Implied volatility. The skew thus represents the market's bias towards calls or puts
How to use volatility skew as an indicator?
When the ratio is greater than one (>1.00), it shows trader sentiment is bullish, when the ratio is less than one (<1.00), it shows trader sentiment is bearish toward a stock.
There are three useful pieces of information that one can glean from an underlying's volatility skew:
1. The direction in which the risk is perceived to be in the underlying.
2. How implied volatility will change relative to movements in the underlying.
3. The prices of the call spread and put spreads on that underlying.
(Note: shouldn’t put too much emphasis on a call/put volatility skew of 1.01 or 0.98, for example. Slight variations like this in the skew are most likely an indication of a little noise in the option prices, not a significant indicator of sentiment. Instead, focus on numbers that are farther away from 1.00 – like 1.26 or 0.81. The farther away from 1.00, the more conviction you can have that traders are actually bullish or bearish.)
How to use it in Option Strategy?
If the skew is positive and the composite implied volatility is in a low percentile consider Put backspread as a strategy. If the skew is negative and the composite implied volatility is in a low percentile, consider Call backspreads as a strategy. If the skew is positive and the composite implied volatility is in a very high percentile, then consider Call ratio spreads as a strategy. If the skew is negative and the composite implied volatility is in a very high percentile, then consider Put ratio spreads as a strategy.
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