Trading Option Skew

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This is a follow up to the "Understanding Option Skew" article I wrote: Understanding Option Skew -- What it is and Why it Exists. Click on the title to read the article.

The next step, after understanding the basics of analysis, is to understand the impact and usability in the context of a trade. I’ll use another historical article to demonstrate this point.

Now that we understand option skew, let’s see how it moves intraday with order flow and then witness one of the most interesting phenomenon about the option market – price discovery.

Trading Option Skew
On 8-20-2010, I wrote an article for TheStreet (OptionsProfits) about BMC, subsequently published on Yahoo! Finance. You can read TheStreet article here: An Unusual Trading Opportunity.

Often times option order flow focuses on one strike (or a group of strikes) and the volatility for that single strike (or group of strikes) changes in response to those trades while the surrounding strikes (or other months) don’t react as quickly. A period of time exists where the options go through price discovery and in that window of time, trading opportunities arise due to skew irregularities. On 8-20-2010, BMC presented such an opportunity.

Order Flow
In the first hour of trading on 8-20-2010, BMC had traded over 4,500 contracts on total daily average volume of just 1,096. In particular, the September 37 calls traded 2200+ times; substantial buying interest. Let’s look to the Skew Tab at that time:



Rather than a normal shaped skew, with each higher strike trading at lower vol than the one higher, what we can see is that the Sep 39 and 40 calls were trading with higher vol than the Sep 38 calls, based on the aggressive long order flow. Or, maybe more clear, what we can see is that the Sep 38 calls had not responded yet.

Price Discovery
This moment in time is the price discovery for the options. One could bet that either the Sep 38 calls would rise in volatility to straighten that line out, or the Sep 40 calls would drop down in vol to straighten the line out. Since we don’t know which one will occur – this was an opportunity to buy the Sep 38 calls (29.5 vol) and sell the Sep 40 calls (31 vol) in anticipation of convergence back to “normalcy.”

Trading Impacts
By the close of the next trading day, if you bought the spread on 8-20-2010 and sold it on 8-21-2010, the spread would have made ~$0.08 on a $0.45 bet (taking out the effect from delta) strictly from the vol. That’s 16.67% in one day on a pure vol scalp. Not too shabby…

This is one real world example that demonstrates how understanding skew and how it “normally” looks can turn an otherwise meaningless chart into a substantial trading opportunity. Skew trades are one of a few type of strategies I consistently search for. Often times it’s large one sided order flow that is the first indicator to a potential skew trade.

This is trade analysis, not a recommendation.

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