Founder, Masters in Trading
What Volatility Skew, Convexity, and Variance Tell You About Market Forecasts
Convexity: Convexity measures how sensitive the price of a financial instrument, such as a stock, is to changes in interest rates. For instance, if a stock’s options have high convexity, their prices will react more significantly to interest rate changes compared to options with lower convexity. If you notice that 5-year options have a convexity of 1.11 – higher than other options with convexity below 1.05 – it implies these options are more sensitive to interest rate changes.
Traders who expect interest rates to rise might see high convexity as an opportunity for profit, anticipating significant price movements. Conversely, those expecting rates to fall might consider this a risk, as prices could move against them more quickly.
Volatility Skew: Volatility skew refers to the difference in implied volatility between options with different strike prices but the same expiration date. Positive skew means higher implied volatility for call options, while negative skew means higher implied volatility for put options. Understanding the skew can help traders anticipate market movements and identify opportunities for buying or selling options at attractive prices.
Variance: Variance measures the volatility of an asset’s returns over a certain period. High variance indicates higher potential for price swings, which can be both an opportunity and a risk. For example, if you expect significant movements in a stock’s price, high variance might make options trading strategies like straddles or strangles more appealing.
Outright vs. Spread Trading: Benefits and Risks
Outright Trading: This involves speculating on the direction of a single stock or option. The benefit is simplicity, as you’re only dealing with one instrument. However, it comes with higher risk due to greater price volatility. If market conditions change unexpectedly, your position might suffer significant losses.
Spread Trading: This involves buying and selling two or more options simultaneously. The benefit is reduced risk since gains in one position can offset losses in another. Spread trading can be less volatile, but it’s more complex and requires a deeper understanding of the market. For example, a call spread might involve buying a call option at one strike price and selling a call option at a higher strike price.
Using Volatility Tools to Manage Market Risk
CME CVOL: The CME Group Volatility Index (CVOL) provides real-time measures of expected volatility for key futures contracts. By monitoring changes in the CVOL, traders can anticipate potential price swings and adjust their positions accordingly. This is valuable for hedging against potential losses or capitalizing on expected gains.
Factors to Consider When Choosing Between Outright and Spread Trading
- Market Conditions: Current market volatility can impact your decision. Higher volatility might make spreads more appealing as they can reduce risk.
- Implied Volatility: Analyze the implied volatility of different options. Volatility skew can indicate potential mispricings and opportunities.
- Risk Tolerance: Your individual risk tolerance should guide your choice. Outright trades might offer higher rewards but come with higher risks, whereas spreads can mitigate some risks.
The Importance of Skew in Options Trading
Understanding Skew: Skew helps you understand market expectations for future price movements. Positive skew (higher call option volatility) suggests a bullish market outlook, while negative skew (higher put option volatility) suggests a bearish outlook. Analyzing skew can help you decide whether to buy or sell options based on perceived market mispricings.
Example: If out-of-the-money call options on a stock show higher implied volatility than put options, it indicates a positive skew. This might signal that traders expect significant upward movement in the stock’s price.
The Role of Variance in Options Trading
Variance Impact: High variance can increase the potential payoff of a trade but also its risk. Traders need to balance the potential rewards against the risks when choosing their positions.
Strategic Use: For instance, in a high-variance environment, you might choose options strategies that benefit from large price movements, such as straddles or strangles, where you buy both a call and a put option at the same strike price.
Summing It Up
Understanding the concepts of convexity, volatility skew, and variance is crucial for making informed trading decisions. These factors provide insights into market forecasts and help you choose the best trading strategies, whether outright or spreads. Analyzing these elements can enhance your ability to manage risk and capitalize on market opportunities.
In addition to what you’ve just read, I’d like to point you toward a video explainer I put together demonstrating how I trade options skews across my services. It’s a great addendum to the lessons in this article and a testament to the power we wield in trading volatility rather than direction.
Remember, the creative trader wins,
Jonathan Rose
Founder, Masters in Trading