Skew Trading

You don't need to trade skew directly, but understanding it helps all options trading. Skew explains why puts often feel expensive, why put spreads collect more premium, and why OTM calls are relatively cheap. This knowledge improves strategy selection even if you never make a pure skew trade.

Put skew is structural, not a temporary mispricing. Institutional investors (pension funds, insurers) must continuously hedge portfolios by buying puts. This constant demand creates permanent buying pressure. Market makers who sell puts charge a premium (higher IV) for crash risk they're taking. There's no 'arbitrage' to remove it.

Rarely in equities, but yes. Call skew (OTM calls more expensive) can occur in commodities (supply shock fears), individual stocks with short squeeze potential, or during takeover situations. The volatility 'smile' (both sides elevated) occurs in FX markets and around binary events like earnings.

Look at the option chain and compare the IV column across strikes at the same expiration. Lower strikes (OTM puts) should have higher IV than ATM, which should be higher than upper strikes (OTM calls). Some platforms have volatility graphs that visualize this directly.

No. Strategies that involve selling puts (credit spreads, iron condors, cash-secured puts) benefit from put skew by collecting extra premium. Strategies buying puts (protective puts, debit spreads) pay extra due to skew. Call strategies are less affected. Understanding skew helps choose better strategies for current conditions.

Use a long risk reversal: sell the expensive OTM put and buy the cheap OTM call. This is 'short put skew' - you profit if skew flattens as fear subsides. Entry when skew percentile >75%; target when skew approaches average. Remember you have bullish delta exposure, so directional moves matter too.

Skew and VIX are positively correlated but not identical. When VIX spikes (fear increases), skew typically steepens (put IV rises more than call IV). However, VIX can be high with normal skew, or normal with steep skew. They measure different aspects of market fear - overall level vs distribution across strikes.

Risk reversals have significant delta (you're synthetically long or short). Options: (1) Accept the directional exposure as part of the trade, (2) Delta hedge with underlying/futures to neutralize direction, (3) Use closer deltas to reduce directional exposure. Most retail traders accept the directional risk and size accordingly.

Generally yes, due to skew - put spreads collect more premium for similar delta exposure. However: (1) Don't sell puts in a strong downtrend just for extra premium, (2) Balance portfolio exposure - too many put spreads creates concentrated risk, (3) Consider the specific skew level - when skew is flat, the advantage diminishes.

Skew changes can take days to weeks. Typical holding: 2-4 weeks or until skew reaches target. Exit by 21 DTE regardless to avoid gamma risk. If skew moves against you significantly, don't hold hoping - cut the trade. Skew can persist longer than expected, especially during sustained fear or calm.

For pure skew: (1) Delta hedge the risk reversal with underlying to remove directional exposure, (2) Add ATM straddle/strangle to neutralize vega (complicated since this changes skew exposure too), (3) Use butterfly spreads which have more curvature exposure than linear skew. In practice, perfect isolation is difficult and costly - most traders accept impure exposure.

SABR is industry standard for fitting skew at a given time. For dynamics, stochastic volatility models (Heston, Bergomi) capture how skew changes with spot and vol movements. For practical trading, empirical observation of skew percentiles and mean reversion is often more robust than complex models. Models help understand; percentiles help trade.

Institutions aggregate skew exposure across all positions into a single portfolio metric. They set limits (e.g., max P&L per 1% skew move), hedge aggregate exposure with risk reversals, and monitor correlations with other risks. Market makers hedge skew dynamically as flow comes in. Vol arb funds actively trade mispricings vs their surface models.

Academic research and practitioners report modest edge from systematic skew strategies: selling steep skew (mean reversion) has positive expectancy; skew momentum can be captured. However, edges are small (Sharpe ~0.3-0.5), transaction costs are significant, and drawdowns occur during stress when skew steepens further. Alpha is available but modest and not easy to harvest.

Variance swap prices equal the integral of squared implied volatility across all strikes, weighted by 1/K². Because of this weighting, put skew (elevated IV at low strikes) increases variance swap prices beyond ATM variance. Steep skew means variance swaps are expensive relative to ATM vol. This creates opportunities for relative value trades between variance swaps and options.