With earnings season in full swing, you may find it particularly useful to trade volatility skews. If you have never heard of a volatility skew, don't panic. It is a simple strategy that professional option traders use successfully.
At certain times, like a pending earnings announcement, an option can become more expensive relative to other options in the same underlying asset, e.g., the implied volatility of the July calls is higher than the October calls. This phenomenon is referred to as volatility skewing and it presents an opportunity to gain an edge. How? By buying the more fairly priced option and selling the more expensive option.
It should be noted that the calls and puts at the same strike price must trade for the same implied volatility; otherwise, reverse arbitrage would eliminate the difference. There is no true arbitrage, however, between different strike prices, so arbitrage cannot eliminate volatility skewing.
How can you determine if an option is overpriced or underpriced?
The answer is implied volatility. High implied volatility translates to higher option prices. If one option has a significantly higher implied volatility than another, it means it is relatively more expensive than the other option.
If there is a significant difference between the implied volatility of two similar options, then sell the overpriced option and buy the more fairly priced option. This helps to tilt the odds more in your favor, giving you a trading edge.
Example of Bank of America (BAC)
Volatility levels can vary between different option exercise prices. Take the following example: stock price is $15.65
- A July BAC call option, with an exercise price of $16, has a volatility level of 60%
- An August BAC call option, with an exercise price of $16, has a volatility level of 37%
The $16 Calls for July are trading at a 62% higher volatility level than the August calls, 60% vs. 37%, making them relatively more expensive than the closer-to-the-money calls. This is a textbook example of volatility skew - implied volatility is skewed toward the short term call option.
What Causes this Volatility Skew?
One reason is outside activities, e.g., earnings announcements, lawsuits, labor strikes, FDA announcements on new drug research, wars, political events, etc. If a market that has been asleep all of a sudden comes alive and starts making big moves, most likely you will see option volatility rise. However, it may not rise evenly over all the different exercise prices and maturities. This uneven or unequal change in implied volatility may provide an option trader with the chance to profit by buying cheap options and selling expensive options.
Setting up the Trade
Buy the more fairly priced option, at the same time sell the most overvalued option. This trade is often referred to as a calendar spread:
- Buy the August $16 calls for $.60
- Sell the July $16 calls for $.20
If you believe the pending earnings announcement on BAC will be mute and the stock's price will remain relatively unchanged, then the implied volatility of the July call option should fall back to approximated 38% - a value closer to the August options. This fall may cause the calendar spread trade to be profitable.
- Approximate value of the August $16 calls after the fall $.57
- Approximate value of the July $16 calls after the fall $.06
In this example the gain would be the difference between the net price of the calendar spread "before" and the net price of the spread "after" (.51 - .40) or 11 cents. Now before you go off and begin to trade volatility skews, it should be noted that a risk still exists. An extreme price move in either direction - which is quite possible after an earnings announcement - may produce a loss in the spread. This loss is limited however to the $.40 investment.
- In certain circumstance options can become overpriced compared to other similar options in the same asset
- Use implied volatility as a measure to find pricing disparities between different options then buy the more fairly priced option and sell the overpriced option
- A volatility skew occurs when one option is relatively more expensive compared to another with a different exercise price or expiry month
- Risk still exists when trading volatility skews
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our new Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.