When trading options one needs to be familiar with the phenomenon of ‘skew’. At first, skew is something that is difficult to grasp, but it is perfectly explicable. This chapter gives the definition of skew and gives the reasons for it.
9.1 WHAT IS SKEW?
Skew is very much related to implied volatility, which is explained in Chapter 4. Chapter 4 explained that, given the price of a specific option in the options market, one can calculate the implied volatility of this option. It appears to be the case that options with lower strike prices have higher implied volatilities. That is to say, that the ’market’ prices options with lower strike prices relatively more expensive than options with higher strike prices. The phenomenon where options with lower strike prices have higher implied volatilities is called ‘skew’. So, when two 3-month options on Royal Dutch/Shell are compared, one with a strike price of $40 and one with a strike price of $32, the one with the strike price of $32 will most definitely have a higher implied volatility. This sounds odd considering that both options are expiring in 3 months’ time and, as mentioned in Chapter 4, the implied volatility is the market’s expectation of the realized volatility of Royal Dutch/Shell in the 3 months ahead on which the strike price has no influence. The reasons for skew will be explained in Section 9.2.
9.2 REASONS FOR SKEW
There are two main reasons for skew which have to be named together, because one ...