Understanding Volatility and Skew

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 |  Includes: VXX, VXZ, XVIX, XXV
by: Surly Trader

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]

SPX Volatility Table: Expirations along Y-Axis and Moneyness/Strikes along X-Axis
Volatility Surface: Makes for a pretty picture but is difficult to read
Because of the overwhelming amount of data, we need a few signals to give us a broad view of volatility levels. I believe that there are two that are the best for developing a market bias. The first is obviously the VIX. The VIX represents a view on the level of short term (~1 month) implied volatility. The VIX tells you nothing about the vertical skew of implied volatility across strikes prices or the shape of the term structure (horizontal skew).
The vertical skew is measured by two published indices: the CBOE’s Skew Index and the Credit Suisse Fear Barometer. Both of these indices have merit and generally relay similar information, but I would say that I like the CSFB index much better because it introduces significantly less noise:
When “skew” spikes to 130 you might get a false signal.
In addition to being a noisy indicator, the Skew index is non-intuitive. A level of 100 in the Skew index means that the expected distribution of log 30-day returns on the S&P 500 is approximately normal according to current option prices. A level above 100 means that the expectation for a couple of standard deviation moves is greater than predicted by a normal distribution and has the following probabilities:

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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.