Options trading can be a powerful tool for making money with volatility skew. Volatility skew refers to the difference in implied volatility between options with different strike prices or expiration dates. Understanding and taking advantage of volatility skew can be a profitable strategy for options traders.
One way to make money with volatility skew is by selling options that have a higher implied volatility than options with a similar strike price but a different expiration date. For example, if a stock has a vertical skew where the implied volatility for a call option with a strike price of $95 is 15%, while the implied volatility for a call option with a strike price of $105 is 10%, a trader could sell the call option with a strike price of $105 and collect a higher premium due to its lower implied volatility. This is known as volatility smile or volatility smirk strategy.
Spread trading strategies such as the calendar spread, diagonal spread, or butterfly spread can also be used to make money with volatility skew. These strategies involve buying and selling options at different strike prices or expiration dates, with the goal of profiting from a change in volatility skew.
Calendar spread (long)
Calendar spread is a great way to trade for IV skew.
An option calendar spread is a type of options trading strategy that involves buying and selling options with different expiration dates but the same strike price. The goal of this strategy is to profit from the difference in time decay between the options and the volatility skew changes. Time decay refers to the rate at which the value of an option decreases as its expiration date approaches.
There are two types of calendar spread, the call calendar spread and the put calendar spread. The call calendar spread involves buying a call option with a longer expiration date and selling a call option with a shorter expiration date. The put calendar spread involves buying a put option with a longer expiration date and selling a put option with a shorter expiration date.
The call calendar spread is typically used when the trader expects the price of the underlying asset to increase in the long-term. The purchased call option with a longer expiration date will increase in value as the underlying asset price increases and the sold call option with a shorter expiration date will decrease in value as it gets closer to expiration.
The put calendar spread is typically used when the trader expects the price of the underlying asset to decrease in the long-term. The purchased put option with a longer expiration date will increase in value as the underlying asset price decreases and the sold put option with a shorter expiration date will decrease in value as it gets closer to expiration.
When the front month’s implied volatility (IV) is higher than the back month’s IV, it is called backwardation. This typically happens when the market is expecting an event or news that may cause a significant price change in the underlying asset. This increase in implied volatility in the front month options can be traded profitably by selling the front month options and buying the back month options and wait for the IV skew to collapse.
NinjaSpread can help you find high or low IV skew calendars very easily. It can also notify you about new ones as they appear during trading hours.
Here is an article on how to use NinjaSpread to find cheap SPX calendars.
Diagonal spread (long)
A diagonal spread is a type of options trading strategy that involves buying or selling options with different strike prices and expiration dates. The goal of this strategy is to profit from the difference in price and volatility between the options. The diagonal spread can be implemented by buying a call or put option with a longer expiration date and selling a call or put option with a shorter expiration date and a different strike price.
For example, if a trader expects the price of an underlying asset to increase in the long-term, they may implement a call diagonal spread by buying a call option with a strike price of $100 and an expiration date of 6 months and selling a call option with a strike price of $110 and an expiration date of 3 months. This allows the trader to take advantage of the expected price increase while also profiting from the time decay of the shorter-term option.
Similarly, if a trader expects the price of an underlying asset to decrease in the long-term, they may implement a put diagonal spread by buying a put option with a strike price of $100 and an expiration date of 6 months and selling a put option with a strike price of $90 and an expiration date of 3 months. This allows the trader to take advantage of the expected price decrease while also profiting from the time decay of the shorter-term option.
There are 4 types of diagonal spreads: Bull Call, Bear Call, Bear Put, Bull Put.
NinjaSpread can help you scan for all types of diagonals depending on your market outlook.
Here is an article on how to find wide and flat but high reward-to-risk diagonals for SPX.
Butterfly spread (short)
A butterfly spread is a volatility trading strategy that involves buying and selling options at three different strike prices.
To create a short butterfly spread, an investor typically sells two options at the middle strike price, and then buys one option at a higher strike price and one option at a lower strike price. The options are usually bought and sold in equal quantities.
Put butterflies are usually better than call ones because if the IV is high, you can buy them cheap. You can use butterflies for directonal and non-directional ideas as well.
There are different variations of butterflies in terms of strike differences, contract sizes, etc. You can create standard and broken-wing butterflies as well depending on your market outlook.
NinjaSpread can help you find any type of butterflies based on your criteria. Here are two articles about how to configure the scanner to help you find butterflies:
Follow for more ideas
If you are interested in more ways how to harness the power of the scanner, please subscribe below.
