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When It Comes to Skews, The Devil is in the Details



Option-implied volatility is a complicated sounding term that simply describes current option pricing levels. It is one of the most important inputs to watch when trading options, but most novice traders tend to focus too much on at-the-money pricing levels. In doing so, they fail to realize that relative option pricing is generally not consistent across strike prices for out-of-the-money options contracts. For example, out-of-the-money puts tend to be priced higher on an implied volatility basis than out-of-the-money calls. This is known as the “skew” — put pricing tends to be ‘skewed’ higher. Skew, when calculated by many common measures will net out the effect of puts and calls, which can make it difficult to see precisely where a move in skew is coming from. This is overlooking important information and could affect investment results. When making decisions on enhancing a portfolio’s yield/return though call or put selling, it is better to separate call skew and put skew.

As the saying goes, “The devil is in the details”: By looking at the put and call skews separately, you are able to make better decisions in locating an edge. For example, a general calculation for skew on one-month options in the S&P500 Index would show that the skew has dropped a fair bit lately. But why has it dropped? Is it because puts have dropped, or is it because calls have risen? By calculating put and call skew separately, we see that most of the effect has come from the calls rising more dramatically than the drop in puts. In fact, 2.5% out-of-the-money calls were recently trading at their highest levels relative to at-the-money calls in almost 19 months. With that steep skew in-mind, as portfolio managers we know that we can sell higher-priced calls against our S&P500 Index holdings than normally would be available, and thereby add value to our portfolio via a covered call strategy. So, when looking at the skew, make sure to recognize where the movement is coming from – it will help you find and make better trades.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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