Options traders have been very frustrated of late; the market's steady march higher has led to shrinking volatility in both real and implied terms, making the prospect of buying or selling options both unappealing and unprofitable. Finding an edge in this environment requires rolling up your sleeves and looking beyond moving averages, momentum and analyst upgrades.
Tracking the volatility patterns of individual stock and index options is a great method for identifying situations that provide a distinct statistical advantage. Most options on individual stocks develop a consistent pattern to their implied volatilities over time, with various strikes and expirations responding to changes in the underlying stock price in a similar fashion. This is referred to as the option's skew.
How Do You Skew?
There are two types of skews: vertical (different strike prices, same expiration date) and horizontal (same strike, different expiration). If you look at the option chain of most equity or stock index options you'll see that implied volatilities tend to decline as strikes move out of the money. This is called a reverse or negative skew. The reason why at-the-money options typically have a higher volatility than out-of-the-money options is rooted in the probability theory of price movement, which shows the likelihood of a small price change is greater than a large one.
For example, a $50 stock is more likely to move $1 than $6, giving at-the-money options a greater probability of experiencing a change in value. This also can be applied to explain why options with more time remaining typically have slightly higher volatility than those with a shorter expiration period. A change in price is more likely to occur during a six-month time frame than within one month.
This pattern is applicable whether the volatility on the underlying stock is 5% or 50%. The skew refers to the relative changes in implied volatilities for a specific series and class of options.
Worth the Effort
Granted, a deviation in volatility patterns is somewhat rare and identifying one can be laborious; many stones need to be turned before an anomalous skew condition is unearthed. But once revealed they offer clues about future price movement and present attractive risk/reward scenarios.
McMillan Analysis, an options research firm, recently completed an exhaustive study in which it crunched 18 months of data involving more than 3,000 issues -- 1,400 incidences of volatility skews turned up. But once parameters were put in place to isolate first-time occurrences (eliminating stocks that displayed a repeated pattern of skews) and require that the skew be sustained for four days (thereby removing one-day events), the list dropped to a mere 97 occurrences.
An essential tenet of options trading is to buy low implied volatility while selling high implied volatility. Since all options are a function of the price of the underlying stock price and its actual volatility, any existing skew in the implied volatility of options must ultimately converge over time and completely disappear by expiration day.
Hey, I Found One ... Now What?
The two scenarios most often responsible for creating a skew are an anticipatory buying of out-of-the-money options ahead of potential price-moving events (such as earnings reports or merger rumors), and a dramatic change in share price following a news event. The latter, especially a steep stock decline, can create a dual skew that is both vertical and horizontal -- as short-term fear causes inflation of both near-term and out-of the-money option prices.
Using spreads, especially on a ratio basis, to buy in-the-money options and sell the higher-volatility out-of-the-money strikes is the most obvious strategy for capitalizing on a positive vertical skew, but it should be applied with caution.
Of the 97 instances identified in McMillan's study, 79 of the stocks recorded a 15% price move over the next 30 days, suggesting that skews can accurately predict increased volatility over that time frame. Using this data, and assuming implied volatility is below 65%, you could likely make a profit by getting long volatility through the purchase of a one-month at-the-money straddle (since volatility is nondirectional). While this may not produce the maximum profit, it helps explain why selling premium or establishing a net naked position such as the above-mentioned ratio isn't advised when a positive skew portends further increases in volatility.
Horizontal skews, in which near-term options have a higher implied volatility than longer-term options, are a great opportunity for establishing calendar spreads. This involves selling a near-term option and simultaneously buying an equal number of options with the same strike but a later expiration date. However, there is a distinct risk in this situation, as explained by the expectations for short-term price volatility, of an assignment of the near-term option sold short, should it go in the money.
Because calendar spreads are one of my favorite strategies, the list below focuses on names that have recently exhibited a horizontal skew. You'll note that each has a catalyst such as recent decline, impending earnings announcement, drug approval issues, court rulings or general accounting/scandal clouds.
The skews on these names are already starting to flatten out, but these types of situations are where to look for future opportunities. Assuming the long-term fundamentals, whether bullish or bearish, remain in place, one can use the temporary price dislocation to get better odds in establishing a low risk/unlimited reward position.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to