How to Make Money Using Option Volatility Skew
Trading Option Skew
Often times option order flow focuses on one strike (or a group of strikes) and the volatility for that single strike (or group of strikes) changes in response to those trades while the surrounding strikes (or other months) don’t react as quickly. A period of time exists where the options go through price discovery and in that window of time; trading opportunities arise due to skew irregularities. On 8-20,2010, BMC presented such an opportunity.
Order Flow
In the first hour of trading, BMC had traded over 4,500 contracts on total daily average volume of just 1,096. In particular, the September 37 calls traded 2200+ times; substantial buying interest. Let’s look to the Skew Tab at that time:
What we can see is that the Sep 37 calls and Sep 40 calls were trading with higher volatility based on the aggressive long order flow. Or, maybe more clear, what we can see is that the Sep 38 calls had not responded yet.
Price Discovery
This moment in time is the price discovery for the options. One could bet that either the Sep 38 calls would rise in volatility to straighten that line out, or the Sep 40 calls would drop down in volatility to straighten the line out. Since we don’t know which one will occur – this was an opportunity to buy the Sep 38 calls (29.5 volatility) and sell the Sep 40 calls (31 volatility) in anticipation of convergence back to “normalcy.”
Trading Impacts
By the close of the next trading day, if you bought the spread on 8-20-2010 and sold it on 8-21-2010 the spread would have made ~$0.08 on a $0.45 bet (taking out the effect from delta) from the volatility, or 16.67% in one day on a pure volatility scalp. Not too shabby…
*This article was contributed by Livevol, Inc. To learn more about Livevol, visit: http://www.livevol.com/ or http://livevol.blogspot.com/
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