I received a good question from a reader:
What do you think about this when measuring option skew? Also, do you know any other ways that I can measure skew? I trade condors mostly but want to figure out when it would be most beneficial to enter one. Is skew essential to look at or can I just look at historical IV?
You can read the original post from OptionPit that describes his intentions with the “Curve Vol Index” here. I will not argue with what is right or wrong about his idea, but merely approach the topic from my own mantra: Keep it simple. With implied volatility, this means that I want clean observations of the data that I intend to study or use as a reference, which forces the study of multiple data points. I feel that this is the only way to keep from getting misled by noise or the interactions of multiple signals put together.
Implied volatility represents a data nightmare. We have thousands of underlying factors, many expirations and numerous strike prices. If we put all of this data together for the S&P 500 it creates an implied volatility surface which looks like this:
[Click all to enlarge]
This table can be interpreted as follows: A level of 130 on the Skew Index implies that there is a 10.4% probability that the 30-day log return on the S&P 500 will be greater than or less than two standard deviations. You can use the VIX as your proxy for the standard deviation input for this equation. So if the VIX is at 10%, a reading of 130 might not mean that much but if the VIX is at 60 the reading would be much more significant.
On the other side of the complexity spectrum is the CSFB Index. The CSFB Index simply asks, “If you sell a three-month call option 10% out of the money on the S&P 500, what put can you afford -- how far out of the money does the three-month put need to be?”
A level of 24 means that if you sell a three-month call 10% out of the money you will have enough premium to purchase a three-month put that is 24% out of the money. Very simple but effective. It tells you that option investors will pay much more for three-month put options than for three-month call options.
The VIX indicates the level of one month implied volatility and the CSFB Index indicates the shape of three-month volatility. You can use the VIX to slant yourself towards option selling or option buying and you can use the CSFB index to indicate how cheap ATM options are over out of the money options or as a general sentiment indicator from the options market. Once you develop your trading idea, then you can look at individual strikes and maturities to see where on the surface you would like to play.