I have spent a large part of my working life in the world of derivatives, or as they are more popularly known “options”. I have always worked as a portfolio manager and my primary acquaintance with options has been through the prism of risk management. This is a good vantage point, since arguably the only people who make money trading options are those who sell options and thereby take on the obligations of the option buyer and who manage those risks prudently.
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One can manage risk in options in many ways – by dynamically hedging one’s options portfolio so as to remain largely delta neutral, by trading volatility either through the purchase and sale of options on the VIX or through purchasing variance swaps, and also by skewness trading. Over the past decade, given the historical low range of volatility in markets, skewness trading has featured much less prominently in risk management of fixed income portfolios, but with the recent spikes in volatility we are likely to see a resurgence of interest in it.
Skewness trading is a strategy that seeks to profit from the difference between the implied volatility of an option and the actual volatility of the underlying asset. When the implied volatility is higher than the actual volatility, the option is said to be overpriced, and a trader can sell the option to profit from the expected decline in volatility. Conversely, when the implied volatility is lower than the actual volatility, the option is said to be underpriced, and a trader can buy the option to profit from the expected increase in volatility.
Skewness trading is a complex strategy that requires a deep understanding of options pricing and volatility. However, it can be a profitable strategy for experienced traders who are able to accurately predict the direction of volatility.
How to Trade Skewness
There are a number of different ways to trade skewness. One common strategy is to sell options that are overpriced and buy options that are underpriced. This strategy is known as a “straddle” or “strangle” trade. Another common strategy is to sell options that have a higher delta than the options that you buy. This strategy is known as a “butterfly” trade.
Which skewness trading strategy is best for you will depend on your individual risk tolerance, time horizon, and market outlook. It is important to do your research and understand the risks involved before you start trading skewness.
Tips for Trading Skewness
Here are a few tips for trading skewness:
- Choose the right market and underlying asset. Skewness trading is most effective in markets with a high degree of volatility.
- Understand options pricing and volatility. It is important to have a deep understanding of how options are priced and how volatility affects the pricing of options.
- Manage your risk. Skewness trading can be a high-risk strategy. It is important to manage your risk carefully.
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Options Trading Rollout
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FAQ on Skewness Trading
Q: What is the difference between skewness and kurtosis?
A: Skewness is a measure of the asymmetry of a distribution. Kurtosis is a measure of the peakedness or flatness of a distribution.
Q: What is the Black-Scholes model?
A: The Black-Scholes model is a mathematical model that is used to price options. The model takes into account the price of the underlying asset, the strike price of the option, the time to expiration, and the volatility of the underlying asset.
Conclusion
Skewness trading is a complex but potentially profitable strategy for experienced traders. It is important to do your research and understand the risks involved before you start trading skewness.
Are you interested in learning more about the roll out of options trading over the years, and how this might help you in your trading?
