Skew Trading

Skew trading is an advanced strategy, but intermediate traders can participate using simpler structures like vertical spreads that have some skew exposure. Pure skew trading with risk reversals and ratio spreads requires deeper knowledge and is best suited for experienced traders.

Regular options trading focuses on direction or volatility level. Skew trading focuses on the relative pricing between strikes - you can profit even if the overall market doesn't move much, as long as the skew normalizes. It's a form of relative value trading.

Put skew is positive because there's consistent demand for downside protection from institutions hedging portfolios. Since 1987's Black Monday crash, markets have priced in crash risk. This demand pushes up OTM put prices relative to ATM options.

The simplest skew exposure comes from vertical spreads. A bull put spread (sell higher strike put, buy lower strike put) has short skew exposure. If skew is steep, you get a better credit because the short leg is more expensive. As skew normalizes, the spread can become more profitable.

You need option chain data with IVs at different strikes. Track the IV at ATM and at 25-delta OTM puts. The difference is your put skew. Build a historical database to calculate percentiles and Z-scores. Some platforms provide skew data directly.

To be vega-neutral (insensitive to parallel IV shifts), match the vega exposure at each strike. If you sell 1 OTM put with A$20 vega and buy ATM options with A$25 vega each, you'd need to adjust quantities. Often, skew trades have some net vega - pure vega neutrality requires precise calibration.

Avoid skew trading when: 1) Skew is justified by genuine crisis/event, 2) Correlation regime is shifting, 3) You don't understand WHY skew is extreme, 4) Liquidity is poor at target strikes, 5) Major events are imminent that could make skew more extreme.

Calculate the net delta (short put delta + long call delta). Buy/sell stock to offset. Monitor daily as delta evolves with price and IV changes. Remember vanna - IV changes affect delta. Plan to rehedge regularly or accept some directional exposure.

25-delta skew measures the 'near wing' - strikes about 1 std dev OTM. 10-delta skew measures the 'far wing' - strikes about 1.5-2 std devs OTM. Far wing skew can be more volatile and trades less liquid, but can offer larger mispricings.

Iron condors benefit from steep put skew. When put skew is steep, the OTM put you sell is more expensive (more credit). When entering iron condors during steep skew, you get better pricing. This is implicit skew trading within your theta harvesting.

Common approaches: 1) SVI (Stochastic Volatility Inspired) parameterization, 2) SABR model, 3) Local volatility (Dupire), 4) Jump-diffusion models. Each has trade-offs between accuracy and complexity. For practical trading, historical skew percentiles often work as well as complex models.

For indices, put skew and implied correlation are related. When correlation is high (stocks move together), index crashes are more severe, so index puts are more valuable (steeper skew). Correlation swaps and dispersion trades exploit this relationship.

Decompose P&L into: 1) Delta P&L (underlying move), 2) Gamma P&L (convexity), 3) Vega P&L (parallel IV shift), 4) Skew P&L (relative IV change), 5) Theta P&L (time decay), 6) Vanna/Volga P&L (second-order). This requires tracking Greeks and IV changes at each strike.

Market makers accumulate short put skew from customer flow (they sell protection). They hedge via: 1) Delta hedging with stock, 2) Gamma hedging with ATM options, 3) Vanna/volga hedging with other options, 4) Accepting residual skew risk for premium. Some offset with index/single-stock dispersion.

The leverage effect (Black 1976) observes that equity volatility rises when prices fall. This is because falling prices increase firm leverage (debt/equity ratio), making the firm riskier. This asymmetry means downside moves are more volatile, justifying higher put IVs.