Decoding Options Skews

(read this so you don't skew yourself)                                                                                                                                                                                                                                                                                                                                                                                                                 October 08, 2024 | [Read Online]( Don Kaufman here. Today we're diving deep into the world of option skews. Now, I know what you're thinking - "Don, why should I care about skews?" Well, let me tell you, understanding these bad boys is like having a secret decoder ring for market sentiment. 🕵️‍♂️ But before we jump into the different types of skews, let's talk about where this magic comes from and how you can spot it in the wild. Skew is all about the relationship between an option's strike price and its implied volatility. It's derived from the market prices of options at different strike prices for the same expiration date. 📊 To find skew on your trading platform, look for the "Option Chain" or "Option Series" view. You'll see a column for Implied Volatility (IV) next to each strike price. If the IV changes as you move up or down the strikes, boom - you've got skew! 💥 On platforms like ThinkOrSwim or TastyWorks, you can even find dedicated skew charts. These visual tools plot the IV against strike prices, making patterns easy to spot. Now, why should you care? Because skews are the market's way of pricing in risk. They're not just some arbitrary numbers; they're telling you where the smart money thinks the danger (or opportunity) lies. 💰 So let's break down these skew types and see what they're really telling us... Flat Skew Flat skew is like the Switzerland of option pricing - neutral and balanced. Here, the implied volatility is roughly the same across all strike prices. You'll typically see this in a calm market where there's no strong directional bias. It's rare, though, because markets are rarely that zen. Smile Skew Picture a happy face, and you've got a smile skew. The implied volatility is higher for both out-of-the-money puts and calls, creating that smile shape. This shows up when the market's expecting big moves but isn't sure which direction. You might see this during earnings seasons or before major economic announcements. Positive Skew When you see out-of-the-money calls priced higher than equidistant out-of-the-money puts, that's what we call a positive skew or forward skew. Here's the deal: this type of skew is telling you that the market's got a bullish bias. It's like the options market is saying, "Hey, we think there's a better chance of a big move to the upside than to the downside." We will see this sometimes with high-flying momentum stocks… Think Tesla or Nvidia when they are on a tear. When you do see it, it might be a good time to think short, because the marketplace has gotten ahead of itself. We also saw this during the dot com bubble, where traders are filled with greed and less concerned with hedging. Negative Skew Now, flip that scenario. When out-of-the-money puts are priced higher than equidistant out-of-the-money calls, that's your classic negative skew or reverse skew. This is the bread and butter of equity options, folks. It's so common that it's practically the default setting in the stock market. Fear is a stronger emotion than greed. When bad news hits, it's like someone yelling "Fire!" in a crowded theater. Everyone rushes for the exits at once, causing rapid, steep declines. Rallies, on the other hand, tend to be more gradual. It's like climbing a staircase versus falling down an elevator shaft. Hedging: Now, institutional investors aren't in the business of losing money. They've got billions under management, and they need to protect it. So what do they do? They buy put options as insurance.  It's like buying fire insurance for your house. You hope you never need it, but you sleep better knowing it's there. This constant demand for puts, especially out-of-the-money puts, drives up their prices relative to calls. Portfolio Managers and Downside Protection: Think about it. If you're managing a big portfolio, your clients aren't going to pat you on the back for making them an extra 2% when the market's up 30%. But if you lose them 30% when the market crashes? You're in hot water. So these managers are always in the market for downside protection, creating a constant bid for put options. Covered Calls: Here's where it gets interesting. Many investors like to generate income by selling covered calls on stocks they own. It's a popular strategy, especially in a flat or slowly rising market. But what does this do? It increases the supply of call options in the market. More supply, all else being equal, means lower prices for calls relative to puts. Putting it all together You've just gotten a sneak peek into how the big boys read the market. But trust me, we've barely scratched the surface! 🏔️ Ready to take your trading to the next level? Then it's time to join my In/Out Advantage program! 💰💪 Here's what you're gonna get: • My secret sauce for decoding market sentiment like a pro 🕵️‍♂️ • High-probability strategies that I've refined over decades 🎯 • Live trading sessions where I break down real trades in real-time 📊 • A community of sharp traders to sharpen your skills with 🤝 Don't let another day go by watching opportunities slip through your fingers. [Join In/Out Advantage now and let's start crushing it together!]( 📈 Are you ready to trade smarter, not harder? Hit that button below! 👇 [I’m In, Don Let’s Trade!]( To your success, Don Kaufman [fb]( [tw]( [ig]( [yt]( Update your email preferences or unsubscribe [here]( © 2024 Don Kaufman - TheoTrade PO Box 24790 Christiansted, Virgin Islands 00824, Virgin Islands, U.S. [Terms of Service](