Trading Volatility Skew with Vega-Neutral Option Positions
Summary
The document explains how to express a view that an option volatility skew is too flat or too steep while limiting exposure to the overall volatility level. Since option prices move with implied volatility, a trader can combine options at different strikes so that their vegas offset, leaving greater exposure to relative pricing across the skew. Delta can also be adjusted with the underlying.
An example uses a put and calls at different strikes to show how a vega-neutral position can be assembled, and why a seemingly simple long cheap-option/short rich-option trade may sell an option the trader believes is underpriced. The proposed alternative combines long positions in both wings with a short position in a middle-strike option. The example is illustrative rather than a general prescription: it provides no market data or risk analysis beyond delta and vega, and a profit depends on the skew repricing as expected.
Key ideas
- A skew view targets relative implied volatility across strikes rather than the overall volatility level.
- Option positions at different strikes can be sized to offset their vegas.
- Delta exposure may require an offsetting position in the underlying.
- A hedge can be vega neutral while still taking positions on the desired side of each option’s relative pricing.
- The example’s potential gain depends on the skew moving toward the trader’s forecast.
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# How could one trade volatility skew if you think it's too flat or steep? # How could one trade volatility skew if you think it's too flat or steep? We all know that you can trade on a forecast of volatility by dynamically hedging, but I'm wondering if there's a similar technique where in you can trade the skew specifically? Let's say you travel back to 1985 before the market has started to price in skew, how could you take advantage of this? ## Answer by Brian B (score 6) https://quant.stackexchange.com/a/41384 Trading the skew is a common practice for traders specializing in options. Let's say you have a 3M skew curve like the blue one below (where I have highlighted a few key strikes) but you think the correct skew curve is more like the red one Let's further assume you unwilling to make a bet on the overall height (level) of the curve. You just want to bet on the shape. There is a monotonic relationship between option price and volatility, so to make your bet you can buy the cheap option on the left, and short the less cheap option on the right all while staying neutral to overall volatility. Option traders track sensitivity of an option to volatility itself, using the word "Vega" to denote it. In addition, they track sensitivity to underlying price, called "Delta". You can make yourself a table of the three interesting options on the original blue curve ``` Side Strike K Price ImpVol Delta Vega Put 125 2 38 -15 20 Call 140 5 30 50 100 Call 155 1 32 10 12 ``` and then find a combination of options that is "vega neutral". In this case it is easy to see you could sell 500 of the K=155 calls and buy 300 of the K=125 puts (for a total cashflow of -100) and have the vega neutral portfolio you desire. (To be delta neutral, you also have to sell 5 of the underlying). Note, however, that this bet sells the K=155 calls you find to be underpriced. Not a good idea. So you would actually prefer to buy 1000 of the K=155 calls and also buy 600 of the K=125 puts. At the same time, you sell 120 of the K=140 calls, and this time you are vega neutral with all bets on the correct side. Once the crash happens, and everybody realizes the true skew in red, you will profit.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.