How do you take advantage of a flat options skew?
Put on a collar.
Skew refers to the difference in pricing between out-of-the-money (OTM) calls and OTM puts, each being equidistant from the at-the-money (ATM) option.
Equity and equity index options are the most traded options products, so we will focus our discussion on options skew and skew theory with index options and foreign exchange products.
In theory, calls and puts that are equidistant from being ATM should be equal in price. After all, both supposedly have the same chance of finishing in-the-money (ITM). In fact, logic would say that the OTM call should trade higher because it can theoretically go infinitely higher, while the OTM put stops gaining when the stock hits zero. And yet, in almost all cases, the OTM put trades higher, often significantly more than the OTM call.
For instance, let’s take a look at the exchange traded fund representing the S&P 500 (SPY). With SPY trading at 210 (as of noon March 5, 2015) it is ideal for illustration purposes. The April 200 put and the April 220 call are equidistant from being ATM. The April 220 call is trading at just 0.15, while the April 200 put is trading at 1.40—nearly 10 times more expensive! This is much higher than usual (see “Equally separate but not equal”).
Why does this occur? There are a few reasons. One is that explosive moves in the stock market are far more often to the downside than to the upside. Another reason is that there is a natural supply imbalance in OTM calls due to the covered writers. Also, there is a natural demand imbalance in OTM puts due to the investors buying downside insurance.
In fact, skew is often a good gauge of market sentiment. With OTM puts representing fear and OTM calls representing greed, andwith the increasingly unstable stock market at or near all-time highs, fear of a move lower is understandably much greater than the greed of a continued move higher.
How about the option skew as it pertains to foreign exchange? This is, after all, a forex issue. Explosive moves can happen in either direction in currencies, so we can expect a less severe put skew, though one usually still exists.
Let’s look at the Nasdaq listed USD/EUR option (XDE). With the euro at this writing trading at 1.101, we will use the April 110 as our ATM strike. The 105 put and the 115 call are equidistant from the ATM strike. The 105 put is trading at 0.25 and the 115 call is trading at 0.20. This shows a negligible skew, certainly different from the SPY. Why? One, there is not the natural upward bias in forex as there is in equities because currency futures and forex markets are just as easy to short as to go long. Also, perhaps more consequential here, is that currently equities are near an all-time high while the euro just set an 11-year low.
Still, this is an extreme example and an experienced option trader will see a low risk opportunity here. Let’s say that you believe the euro is due for a corrected rally but do not believe the market will reverse for long or for more than say 5%. You are bullish short-term but want protection. A good play here is the collar. It looks like this:
You can buy the euro and buy the 105 put as downside protection for $2,500. Then you sell the 115 call and collect $2000 in premium, which comes close to financing your protective put. Your risk is capped at $5,500; your highest profit potential, also capped, is $4,500 with an ideal expiration at 115.
The Euro skew shown above also demonstrates a near equal bias between euro bulls and euro bears. All experienced options traders keep a close eye on the options skew.