What affects the skewness of the OPTION PRICE distribution?

Question

I'm thinking of trading on the skewness of the OPTIONS on S&P 500 index. I've read that it is good to initialise the trade when the skewness is very negative. Havig obtained a sample of the option skewness over a couple of years, I'm curious at what level the skewness needs to reach inorder to trade?

Answer 1

What type of trade do you want to put on?  That will dictate whether skew is good for your position.  For example, buying a put debit spread would be great if there's lots of put skew but selling the same spread would be bad if there where lots of put skew.

Answer 2

You have asked the question of all questions in volatility arbitrage. When is the skew a sell and when is it a buy?

Skew is based on two things:

1) The supply and demand in OTM calls and OTM puts in a specif underlying, in this case the SPX. Basically, more buyers in OTM calls will flatten the skew ,and more buyers in the OTM puts will steepen the skew.

2) When engaging  in a volatility dispersion strategy, you will trade the individual skews of all of the underlying stocks. In this case all 500 stocks in the SPX, or at least a statistical representation thereof, and trade the skew in the SPX against it. Therefor the skew of the underlying stocks will effect the skew of the SPX.

When you trade just the SPX skew (I think it's save to assume you are not diving into dispersion trading and arb the entire underlying options portfolio, unless you are a hedge fund, asking an opinion non Yahoo!, lol...) you will end up trading risk reversals or spreads. Look at your data and try to figure out what is statistically outside the range of past skew behavior and trade around it.

But keep in mind, skew can be very dynamic and move around intraday. And even if skew seems very cheap or very expensive, if a market keeps trending up, no skew is to expensive and vice versa for a down trend.

Hope this helps.