Exploiting The Volatility Skew
The basic idea here is to purchase value. Suppose the underlying is trading at 110 and calls A, B and C share the same expiration date, with strike prices of 100, 110, and 120, and implied volatilities (IVs) of 20%, 30% and 40%, respectively (see table, below right)
Option A is underpriced relative to both B and C, and option C is overpriced relative to both A and B. Option B is underpriced relative to option C and overpriced relative to option A. This is not characteristic of the volatility “smile”–the middle strike does not have a lower IV than the two outer strikes. But let’s use this example for illustration.
| Option | Strike | IV | Delta |
|---|---|---|---|
| A | 100 | 20% | .3 |
| B | 110 | 30% | .5 |
| C | 120 | 40% | .7 |
The indication is to sell the high IVs and buy the low IVs. So, looking first at two-option spreads, you would look at a spread that is long A and short B or C, or long A or B and short C. If you are long A and short B, to make the spread delta neutral you will have +3 As and -5 Bs. If you are long A and short C, the delta neutral spread will have +3 As and -7 Cs.
The delta of each spread will change as the price of the underlying moves and as the time to expiration becomes smaller, and the delta of the (+3 A, -7 C) spread will change faster than that of the (+3 A, -5 B) spread. This is just to say that the gamma of the (+3 A, -7 C) will be larger than the gamma of the (+3 A, -5 B) spread. So you might prefer the more delta-stable spread, as you will need to adjust the spread ratio less frequently.
Offsetting the lower-gamma advantage of the (+3 A, -5 B) spread is the smaller edge in this spread–A has an IV of 20% and B has an IV of 30%, where if you take the (+3 A, -7 C) spread, C has an IV of 40%.
More on this topic in the next commentary.